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BUSINESS  FINANCE 

A  PracticalStudy  of  Financial  Manage- 
ment in  Private  Business  Concerns 


BY 

WILLIAM  H.  LOUGH 

President,  Business  Training  Corporation, 
New  York  City;  formerly  Professor  of 
Finance,  New  York  University  School  of 
Commerce,  Accounts  and  Finance;  Author 
of  "Corporation  Finance,"  "Le.ctures  on 
Panics  and  Depressions,"  "Banking  Oppor- 
tunities in  South  America,"  etc. 


TEXT  EDITION 


(  FiftU  Printing )  .  , 


NEW  YORK 

THE  RONALD  PRESS  COMPANY 
fs,  \,-  '     1919 


\  ^  <^ 


Copyright,  1917,  by 
The  Ronald  Press  Company 


PREFACE 

This  book,  as  its  name  indicates,  is  concerned  with  the 
every-day  financial  problems  of  the  private  business  concern. 
The  point  of  view  taken  throughout  is  that  of  an  organizer 
or  financial  manager  of  an  enterprise.  While  the  book  deals 
primarily  with  business  conditions  and  financial  practice  in 
the  United  States,  it  includes  many  references  also  to  the  ex- 
perience and  practice  of  other  countries  which  may  yield 
suggestions  of  value  to  American  business  men. 

Many  social  and  economic  questions  are  necessarily 
touched  upon  incidentally.  These  questions,  however,  in  the 
author's  judgment,  belong  to  a  separate  field  of  study;  no 
attempt  is  made,  therefore,  to  discuss  them  at  any  length. 

The  subject  matter  of  the  book  falls  naturally  into  five 
distinct  parts : 

Part  I  begins  with  a  brief  exposition  of  the  essential 
principles  of  all  sound  financing;  it  is  devoted  for  the 
most  part  to  a  description  of  the  different  forms  of  finan- 
cial organization  of  business  enterprises,  taking  up  in  turn 
the  individual  proprietorship,  the  firm  or  partnership,  and 
the  corporation. 

Part  II  discusses  the  various  forms  of  security  issues 
and  the  manner  in  which  they  may  be  combined  and  or- 
ganized as  determined  by  the  basis  of  capitalization  of  the 
particular  enterprise. 

Part  III  treats  of  the  methods  of  raising  capital 
through  the  sale  of  securities  and  the  usual  forms  of 
promotion  and  underwriting. 

Part  IV  deals  with  efficient  financial  management ;  how 
capital  funds  are  invested;  how  the  amount  required  for 
working  capital  is  ascertained;  the  proper  management  of 

lii 

416663 


iv  PREFACE 

capital  and  income  through  budgets;   and   some   of  the 
financial  standards  which  should  be  kept  in  view. 

Part  V  treats  of  financial  mismanagement  and  irregu- 
larities, and  of  the  processes  of  reorganization. 

This  very  brief  review  is  enough  to  make  clear  the  main 
purposes  of  the  book  and  the  groups  of  business  men  to  whom 
it  is  designed  to  prove  useful. 

The  first  group,  whom  the  author  has  had  constantly  in 
mind,  consists  of  organizers,  directors,  and  executive  officers 
of  business  concerns  of  all  classes.  It  is  hoped  that  they  will 
obtain  from  the  book  many  helpful  suggestions  which  they 
can  put  to  practical  use. 

The  second  group  consists  of  bankers,  bond  dealers,  and 
other  financial  men  who  are  continually  investigating  and 
criticizing  the  financial  management  of  enterprises. 

There  is  a  third  group,  composed  of  engineers,  lawyers, 
accountants,  and  other  professional  men,  who  are  frequently 
called  upon  to  advise  as  to  financial  questions,  although  they 
are  not  necessarily  well  informed  on  these  subjects. 

The  present  edition  is  specially  intended  for  a  fourth 
group — which  fortunately  for  the  business  of  the  country 
is  rapidly  growing  in  numbers — made  up  of  students  of 
business  and  economic  subjects,  including  not  only  those  en- 
rolled in  universities  or  other  institutions  of  learning,  but  also 
the  tens  of  thousands  of  young  business  men  who  realize 
that  long  continued  study  is  required  in  order  to  achieve 
even  a  reasonable  mastery  of  the  intricacies  of  modern 
business. 

For  the  use  of  this  group  the  practical  material  contained 
in  the  first  four  parts  of  the  general  edition  of  this  work  has 
been  retained  in  full  detail  and  with  all  supporting  illustra- 
tions, save  in  the  chapters  discussing  budgets  and  financial 
standards.  Here,  where  the  subject  is  comparatively  new  and 
practice  is  unsettled,  much  of  the  theory  and  illustration  has 


PREFACE  V 

been  dropped.  In  Part  V,  where  detailed  information  is  not 
of  the  same  vital  importance  to  the  student,  the  more  essen- 
tial features  have  been  retained,  but  much  of  the  illustration 
and  some  of  the  discussion  have  been  omitted. 

Literature  on  the  subject  of  business  finance  is  so  scanty 
that  the  present  book  necessarily  breaks  fresh  ground  to  a 
considerable  extent,  and  this  must  be  the  author's  excuse  if 
sometimes  the  treatment  of  a  topic  seems  to  be  incomplete. 
This  remark  applies  with  special  force  to  the  chapter  on 
"Financial  Standards" — a  subject  to  which  a  great  amount 
of  research  could  profitably  be  devoted. 

William  H.  Lough 
New  York  City, 

April  9,  1917. 


CONTENTS 


Part  I — Finance  and  Business  Organization 

CHAPTER  PAGE 

I     Principles  of  Financing i 

II     Forms  of  Business  Enterprises ii 

III  The  Corporation 25 

IV  The  Corporate  Form — Advantages  and  Disad- 

vantages    45 


Part  II — Capital 

V     Owned  Capital 64 

VI     Borrowed  Capital — Short-Term 105 

VII     Borrowed  Capital — Long-Term 130 

VIII     Basis  of  Capitalization 172 


Part  III — Securing  Capital 

IX     Sources  of  Capital  Funds 201 

X     Promotion 229  • 

XI     The  Promoter 250    - 

XII     Promoting  Combinations 265 

XIII  Selling  Securities  Direct 291  / 

XIV  Selling  Securities  Through  Dealers 319 

XV     Underwriting 339 

vii 


viii  CONTENTS 

Part  IV — Internal  Financial  Management 

CHAPTER  PAGE 

XVI  Investment  of  Capital  Funds 355 

XVII  Calculating  Requirements  for  Working  Capital.  380/ 

XVIII  Determination  of  Net  Income 415^ 

XIX  Dividends   435 

XX  Surplus   465 

XXI  Budgets 482 

XXII  Financial  Standards 489 


Part  V — Financial  Abuses  and  Involvements 

XXIII  Exploitation  by  Officers 499  - 

XXIV  Exploitation  by  Directors  and  Majority  Share- 

holders      507  ^ 

XXV     Insolvency  and  Receivership 514 

XXVI     Reorganization 529 


I 


BUSINESS  FINANCE 

Part  I — Finance  and  Business  Organization 


CHAPTER    I 
PRINCIPLES  OF  FINANCING 

Scope  of  Subject 

In  this  volume  Is  considered  the  subject  of  securing  and 
handHng  money  and  credit  for  business  enterprises.  If  these 
terms  were  used  with  strict  accuracy,  the  statement  might  be 
shortened  by  leaving  out  the  reference  to  money;  for,  after 
all,  credit  in  one  form  or  another  is  almost  the  only  element- 
with  which  we  have  to  deal.  But  it  is  not  necessary  here  to 
enlarge  upon  these  technical  limitations. 

Financing  deals,  first,  with  the  raising  of  the  initial  capital 
needed  for  business  enterprises,  what  securities  to  issue,  how 
and  to  whom  they  should  be  sold,  how  best  to  utilize  the 
funds  thus  secured,  together  with  their  proper  apportion- 
ment for  plant,  equipment,  and  working  capital;  second,  with 
the  accurate  determination  of  profits  and  their  allocation  to 
dividends,  surplus,  sinking  fund  and  reserves,  and  the  en- 
largement of  capital  permanently  invested.  It  is  concerned 
with  the  forecasting  of  business  development  and  resulting 
financial  needs  and  with  provision  for  the  business  equivalent 
of  a  "rainy  day." 

Unskilful  Business  Financing 

Financing  is,  perhaps,  the  least  understood  subject  in  the 
field  of  business,  not  even  excepting  accounting.     A  great 

I 


\!^^"^^^  :'^<^li^A^^^  AND   BUSINESS   ORGANIZATION 

many  men  have  proved  themselves  able  and  successful  as 
producers,  organizers,  and  sellers,  but  have  failed  utterly  in 
handling  their  financial  problems. 

A  conspicuous  example  was  the  late  Mr.  George  Westing- 
house,  the  brilliant  inventor,  organizer,  and  salesman  who 
founded  the  Westinghouse  Electric  and  Manufacturing  Com- 
pany, the  Westinghouse  Air  Brake  Company,  and  other  en- 
terprises. Mr.  Westinghouse  made  a  success  of  every  busi- 
ness enterprise  he  touched  except  in  so  far  as  financing  was 
concerned.  He  apparently  was  not  familiar  with  financial 
methods  and  did  not  possess  the  foresight  to  keep  his  enter- 
prises properly  provided  with  cash  as  they  progressed.  Con- 
sequently, he  was  twice  faced  with  serious  embarrassment 
and  in  the  end  was  compelled  to  relinquish  the  management 
of  the  Westinghouse  Electric  and  Manufacturing  Company. 

This  case  is  not  an  uncommon  one.  In  fact,  it  is  quite 
generally  true  that  men  of  an  optimistic,  emotional  turn  of 
mind  who  make  good  as  producers  and  salesmen  are  just  the 
men  who  deceive  themselves  as  to  their  own  financial  afiFairs 
and  often  wreck  a  promising  business  on  some  financial  reef. 

It  is  surprising  to  find  how  many  directors  of  important 
corporations  give  insufficient  attention  to  the  basic  financial 
problems  of  corporate  business.  Frequently  insolvency,  which 
should  have  been  clearly  foreseen,  comes  upon  a  board  of 
directors  when  they  fancy  their  company  to  be  at  the  height 
of  prosperity.  This  was  true,  for  instance,  of  the  insolvencies 
during  recent  years  of  the  National  Cordage  Company,  the 
American  Malting  Company,  the  National  Asphalt  Company, 
the  United  States  Realty  Company,  the  New  England  Cotton 
Yarn  Company,  and  the  Westinghouse  Electric  and  Manu- 
facturing Company. 

Among  smaller  concerns  the  amount  of  ignorance  regard- 
ing financial  management  is  even  greater.  Every  experienced 
business  man  probably  has  observed  instances  where  profitable 


PRINCIPLES   OF   FINANCING  - 

o 

enterprises  were  half  developed  and  then  abandoned  for  lack 
of  funds,  when,  in  nine  cases  out  of  ten,  the  whole  financial 
process  might  have  been  figured  out  in  advance  and  the  neces- 
sary funds  raised  with  little  dif^culty.  Instead,  the  enterprise 
too  often  drags  out  a  painful  existence  for  a  few  months  or 
a  few  years,  eats  up  the  owner's  capital,  and  at  the  end  leaves 
him  a  poorer,  but  not  always  a  wiser,  man. 

Financing  and  Accounting 

Poor  financing  is  apt  to  be  combined  with  poor  account- 
ing; and  in  that  case  the  unfortunate  owner  cannot  enjoy 
even  the  empty  satisfaction  of  a  post-mortem  diagnosis. 

This  brings  up  a  question  on  which  there  has  been  much 
confusion  of  thought — the  question  as  to  the  dividing  line 
between  the  subject  of  financing  and  the  subject  of  account- 
ing. It  is  not  purely  an  academic  question,  for  in  many  busi- 
ness concerns  the  head  of  the  accounting  department  and  the 
head  of  the  financial  department  are  continually  treading  on 
each  other's  toes.  Or,  a  still  worse  thing  happens;  the  two 
offices  are  combined  under  the  management  of  one  person. 

There  is  undoubtedly  a  twilight  zone  between  the  two 
subjects.  When  we  come  to  discuss  rates  of  depreciation, 
sinking  fund  requirements,  valuation  of  good- will,  and  the 
like,  we  shall  be  in  constant  danger  of  trespassing  into  ac- 
counting territory;  while,  on  the  other  hand,  our  friends  the 
accountants,  especially  public  accountants,  have  not  hesitated 
to  make  many  bold  forays  into  financial  fields.  Frequently 
they  are  called  upon  to  advise  their  clients  as  to  securing 
bank  loans,  the  proper  types  of  bonds  and  shares  to  issue,  the 
proper  investment  of  capital  funds,  the  declaration  of  divi- 
dends, and  so  on.  However,  bankers,  treasurers  of  corpora- 
tions, and  finance  committees  are  becoming  more  and  more 
successful  in  repelling  these  incursions,  thus  restricting  the 
accountant  to  his  proper  activities. 


4  FINANCE   AND   BUSINESS    ORGANIZATION 

We  need  not  enter  Into  the  technicalities  of  the  friendly 
controversy.  A  broad  distinction,  however,  between  the  two 
^^elds  of  work  and  study  may  easily  be  made.  Accounting, 
properly  speaking,  deals  with  recording  and  analyzing  results 
that  have  been  achieved ;  and  its  growing  value  and  popularity 
is  due  to  the  general  recognition  that  the  conclusions  drawn 
by  skilled  accountants  may  profitably  be  used  as  a  foundation 
for  future  action. 

Financing,  on  the  other  hand,  deals  not  with  recording 
and  analyzing  but  with  getting  positive  results;  how  to  raise 
money  for  various  business  enterprises;  what  securities  to 
issue ;  to  whom  they  should  be  sold ;  and  how  to  use  the  pro- 
ceeds to  the  best  advantage  for  the  promotion  of  the  business. 
These  are  some  of  the  typical  problems  clearly  outside  the 
scope  of  accounting  which  are  discussed  in  this  volume. 

Two  sister  subjects  in  the  field  of  finance  are  investing  and 
banking.  Investing  deals  with  the  process  of  supplying  capital 
to  business  and  public  undertakings  for  their  permajnent  use, 
that  is,  as  original  investments  or  for  long-term  loans.  Bank- 
ing deals  with  the  process  of  supplying  capital  to  these  enter- 
prises for  their  temporary  use,  that  is,  for  short-term  loans 
exclusively.  Both  of  these  processes  are  referred  to  frequently 
but  they  are  of  so  much  importance  that  they  will  be  treated 
separately.  (See  Chapters  V,  VI.)  It  may  be  noted  that 
both  investing  and  banking  deal  with  supplying  credit,  while 
j  financing  deals  with  obtaining  and  using  credit.  The  same 
problem  is  involved  in  both  but  is  treated  from  different  points 
'of  view. 

Public  Financing  and  Business  Financing 

Another  cognate  subject,  which  is,  however,  outside  the 
scope  of  this  book,  is  public  financing,  which  deals  with  the 
securing  and  handling  of  money  and  credit  for  governments — 
national,  state,  and  municipal. 


PRINCIPLES   OF   FINANCING  5 

Public  financing  has  been  much  studied  and  written  about ; 
many  valuable  books  have  been  published  on  such  subjects 
as  taxation,  governmental  loans  and  their  repayment,  regula- 
tion of  governmental  expenditures,  and  the  like.  Business 
financing,  on  the  other  hand,  has  been  surprisingly  neglected ; 
there  are  only  about  a  dozen  books  and  a  few  magazine  ar- 
ticles devoted  wholly  to  this  subject,  though,  of  course,  a 
great  deal  of  valuable  information  may  be  gleaned  from  mis- 
cellaneous publications. 

Yet  the  relative  importance  of  the  two  subjects — public 
financing  and  business  financing — seems  to  be  in  inverse  ratio 
to  the  amount  of  study  that  has  been  given  to  each. 

In  19 1 2,  according  to  the  United  States  Census,  the  total 
value  of  all  the  property  existing  in  the  United  States  was 
approximately  $187,000,000,000,  of  which  $12,000,000,000 
or  7%  was  exempt  from  taxation  and  $175,000,000,000 
or  93%  was  taxable.  Making  reasonable  allowances  for  the 
property  of  religious,  educational,  and  philanthropic  institu- 
tions in  the  tax-exempted  classification,  there  remains  only 
3%  to  5%  of  the  wealth  of  the  United  States  that  is  directly 
owned  by  national,  state,  and  municipal  governments.  Against 
this  there  is  93%  owned  and  managed  by  individuals,  firms, 
or  corporations.  On  Its  face  the  comparison  Indicates  that 
the  neglected  subject  of  business  financing  Is  worthy  of 
thorough  and  careful  study. 

There  are  probably  two  chief  reasons,  both  Inadequate, 
why  business  financing  has  been  comparatively  overlooked. 
One  Is  the  false  notion,  prevalent  until  recent  years,  thatt- 
private  business  is  a  simple  activity  unworthy  of  serious  con- 
sideration by  Intellectual  men.  Another  reason  Is  that  data  5 
concerning  methods  of  business  financing  methods  are  not 
conveniently  assembled  in  volumes  or  in  reports  or  statistics, 
but  must  be  gathered,  in  large  part,  at  first  hand  from  active 
business  men  and  from  general  business  experience.    As  time 


6  And  i^usiNEss  organization 

goes  on,  the  subject  will  doubtless  be  more  fully  investigated 
and  more  information  will  be  made  available. 

It  will  become  evident  as  we  proceed  that  financing  is 
related  also  to  other  business  subjects,  such  as  production, 
selling,  organization,  etc. ;  but  there  is  no  confusion  in  its 
relation  to  these  subjects  and  no  necessity  for  explanation. 

Simplicity  of  Business  Finance 

It  is  popularly  supposed  that  many  difficulties  are  en- 
countered in  solving  the  problems  of  business  finance.  One 
writer  even  has  defined  the  science  of  business  finance  as  "the 
modern  black  art,"  as  if  it  were  something  mysterious  and 
uncanny.  Yet,  whatever  may  be  said  of  the  difficulties  per- 
taining to  actual  practice,  the  essential  principles  of  business 
finance  are  simple  and  can  be  readily  understood  by  anyone. 
This  can  be  illustrated  by  the  close  analogy  existing  between 
the  financial  problems  of  the  business  enterprise  and  the  finan- 
cial problems  encountered  by  the  ordinary  individual  in  his 
daily  life. 

The  individual  possesses  both  tangible  and  intangible 
assets.  He  has  money,  tools,  land,  and  other  material  things. 
Also,  he  possesses  health,  skill,  knowledge,  and  other  assets 
that  are  intangible.  Business  divides  its  assets  into  things 
tangible  and  intangible  in  the  same  way ;  its  plant,  equipment, 
stock,  and  cash  being  tangible  assets ;  while  its  good- will,  trade 
name,  patents,  and  copyrights  are  intangible  assets. 

The  individual  has  his  capital  and  his  income  and  from 
these  he  must  take  his  expenditures:  first,  to  keep  himself 
in  condition  to  do  business ;  second,  to  increase  his  productive 
and  consequently  his  earning  power ;  third,  to  reserve  a  portion 
of  his  income.  He  knows  the  laws  of  thrift  and  prudence,  and 
knows  that  if  he  will  obey  them  he  will  prosper. 

It  will  be  shown  that  precisely  the  same  kind  of  wisdom 
and  foresight  is  required  to  invest  properly  the  capital  and 


PRINCIPLES   OF   FINANCING  7 

income  of  a  great  business  so  that  it  shall-  continue  to  grow 
and  prosper  and  shall  not  be  short  of  funds  and  credit  should 
an  evil  day  unfortunately  come.  The  business,  great  or  small, 
that  does  not  keep  its  expenditures  within  its  income  is  as 
certain  to  come  to  grief  as  the  individual  who  spends  more 
than  he  earns. 

An  individual  should,  from  time  to  time,  take  an  inventory 
of  his  resources  and  liabilities,  physical,  intellectual,  and 
spiritual  as  well  as  material,  and  thus  determine  whether  he 
is  becoming  richer  or  poorer.  In  like  manner,  every  business 
should,  at  regular  intervals,  take  an  inventory,  balance  all  ac- 
counts, subtract  losses  and  add  gains,  and  thus  ascertain 
whether  it  is  gaining  ground  or  falling  behind. 

Borrowing  Money 

All  our  greater  businesses  are  conducted  largely  with  bor- 
rowed money;  and  in  this  matter  we  may  carry  our  analogy 
with  the  individual  yet  further.  It  is  well  to  remember,  how- 
ever, that  in  borrowing  for  a  legitimate  purpose  we  are  not 
engaged  in  that  shiftless  borrowing  condemned  by  sages  and 
moralists.  Polonius  said: 

Neither    a  borrower  nor  a  lender  be; 

For  loan  oft  loses  both  itself  and  friend 

And  borrowing  dulls  the  edge  of  husbandry. 

But  this  was  not  said  in  reference  to  borrowing  or  lending 
money  for  profitable  business  purposes. 

When  a  young  man  makes  a  long-term  loan  and  pays 
interest  on  it  in  order  that  he  may  take  a  college  course  or 
prepare  for  a  profession,  he  is  not  acting  foolishly  but  wisely; 
for  the  money  will  bring  him  a  wealth  of  skill  and  knowledge 
that  will  enable  him  to  repay  both  loan  and  interest,  and  dur- 
ing his  life  the  transaction  will  increase  both  his  usefulness 
to  society  and  his  earning  power.     In  the  same  way,  when  a 


8  FINANCE   AND   BUSINESS   ORGANIZATION 

business  concern  can  borrow  money  to  enlarge  its  plant,  make 
needed  improvements,  develop  the  enterprise,  and  increase 
its  profits,  such  borrowing  is  not  only  permissible  but  com- 
mendable. 

There  are,  however,  some  obvious  limitations  which  will 
at  once  be  recognized.  No  individual  should  borrow  money 
unless  it  can  be  used  to  advantage  and  repaid  promptly  when 
it  falls  due.  For  this  reason,  short-term  borrowing  is  usually 
not  good  business  for  either  an  individual  or  a  business  unless 
it  is  to  "swing"  some  transaction  that  can  be  quickly  com- 
pleted, or  to  tide  over  a  brief  stringency. 

Permanent  and  Transient  Investments 

We  can  carry  our  analogy  still  further.  All  business 
assets  belong  in  one  or  the  other  of  two  classes:  those  that 
are  fixed  and  permanent,  and  those  that  are  temporary  and 
designed  to  be  converted  into  cash  within  a  short  time;  the 
first  class  is  known  as  **fixed  assets''  and  the  second  as  "work- 
ing assets."  In  every  business  there  should  be  a  proper  pro- 
portion between  the  amount  invested  in  fixed  assets  and  the 
amount  reserved  for  working  assets. 

Both  the  individual  and  the  business  concern  often  fail  to 
observe  the  necessary  proportions.  Not  infrequently  an  agri- 
culturist buys  more  land  than  he  can  profitably  work  and  we 
have  a  "land  poor"  farmer.  Many  country  merchants  buy 
more  stock  than  they  can  immediately  sell.  The  less  salable 
portion  becomes  shopworn  and,  as  a  consequence  of  this  need- 
less tying  up  of  money,  they  are  without  funds  to  replace 
the  more  salable  articles.  Many  businesses,  both  great  and 
small,  have  met  disaster  because  the  necessary  amount  of 
working  capital  was  not  correctly  estimated,  too  much  being 
invested  in  plant  and  equipment  and  an  insufficient  amount 
being  left  to  conduct  the  business. 

It  is  always  advisable  to  possess  an  emergency  fund  or 


PRINCIPLES    OF   FINANCING  g 

some  quickly  convertible  assets.  From  time  to  time,  oppor- 
tunities offer  which  can  only  be  taken  advantage  of  by  the 
possessor  of  ready  cash,  and  when  this  propitious  chance 
occurs  the  forehanded  business  man  can  act  quickly  and 
profitably. 

Application  of  Income 

Both  the  individual  and  the  business  concern  possess  a 
certain  income  from  which  living  or  supporting  expenses  must 
be  drawn;  therefore,  to  both  the  individual  and  the  business 
concern  comes  the  question  of  how  much  of  the  income  may 
properly  be  utilized  for  non-paying  purposes,  such  as  pleasure 
in  the  case  of  the  individual  and  dividends  in  the  case  of  the 
business  concern. 

At  the  beginning  of  each  year  the  individual  should  esti- 
mate his  needs.  The  business  establishment  should,  in  like 
manner,  determine  what  amount  of  earnings  should  be  set 
aside  for  a  reserve,  what  should  be  applied  to  each  depart- 
ment for  maintenance,  depreciation,  etc.,  and  whether  an  in- 
crease or  curtailment  of  income  may  be  expected.  Item  by 
item,  this  estimate  should  be  scrutinized  to  learn  where  an 
outlay  may  be  profitably  curtailed,  or  where  an  outlay  may  be 
made  for  ultimate  benefit.  Such  a  proceeding  is  a  practical 
method  of  planning  finances;  it  can,  and  should  be,  con- 
sistently followed. 

Elementary  Rules  of  Financing 

The  following  elementary  rules  of  business  finance  apply 
alike  to  individuals  and  to  the  largest  enterprises;  the  re- 
mainder of  this  work  consists  practically  of  the  application 
of  these  general  rules  to  various  business  problems. 

I.    Study  and  utilize  all   sources   of   capital,   including 
earning  power  and  credit. 


lO  FINANCE  AND   BUSINESS   ORGANIZATION 

2.  Do  not  be  afraid  to  borrow  for  legitimate  business 

development  when  you  can  earn  profits  and  repay 
the  loan  when  due. 

3.  Do  not  dissipate  capital  on  side  lines  and  outside  in- 

vestments. 

4.  Systematically  accumulate  assets,  both  tangible  and 

intangible. 

5.  Always  keep  available  sufficient  cash  and  convertible 

assets   to   meet   emergencies   and   to   seize   special 
opportunities. 

6.  Use  income  sparingly  for  living  expenses  and  pleasure, 

but  freely  for  business  maintenance  and  develop- 
ment. 

7.  Use   foresight — which   is  the   cardinal  virtue  in   all 

financial  operations;  make  budgets  to  govern  all 
expenditures. 

These  are  the  prudent,  indisputable  rules  for  sensible 
financing.  They  have  been  preached  and  proven  over  and 
over  again  for  many  centuries  past.  The  wisdom  which 
these  homely  rules  embody  applies  just  as  truly  to  the  business 
of  the  Standard  Oil  Company  and  the  United  States  Steel 
Corporation  as  to  the  affairs  of  John  Smith.  A  man  who 
can  grasp  these  principles,  hold  them  continually  before  his 
eyes,  and  apply  them  intelligently,  is  bound  to  handle  his 
finances  wisely  both  in  his  business  and  in  his  private  life. 

However,  simple  as  they  are,  to  apply  these  fundamental 
principles  to  all  the  complex  situations  which  arise  in  modern 
business  is  no  easy  task.  Sound  financing  calls  for  clear  think- 
ing and  a  wide  range  of  knowledge. 


CHAPTER    II 

FORMS  OF  BUSINESS  ENTERPRISES 

Basic  Types  of  Business  Organization 

Throughout  the  world,  wherever  business  enterprises  are 
carried  on,  there  are  to  be  found  three  basic  forms  in  which 
the  ownership  of  these  enterprises  is  held. 

1.  The  individual  owning  outright  his  own  business  and 

usually  managing  it  himself  without  much  co- 
operation or  assistance. 

2.  A  group  of  owners,  working  together  under  some 

form  of  partnership  agreement. 

3.  The    impersonal    owner — the    corporation — standing 

between  the  business  and  the  individuals  who  have 
various  kinds  and  degrees  of  claims  upon  the  busi- 
ness. 

These  three  basic  forms  are  combined  and  recombined  in 
imany  different  ways  under  the'  laws  and  customs  of  the 
various  commercial  countries,  but  analysis  always  reveals  one 
or  the  other  of  the  three  forms  predominating. 

This  is  shown  by  the  short  description,  which  has  been 
sodded,  of  three  other  forms  of  business  organization  not  often 
used  but  of  interest,  as  showing  how  difficult  it  is  to  get  away 
from  the  basic  types.  These  are  the  limited  partnership, 
the  joint-stock  company,  and  the  association  under  deed 
of  trust. 

The  first  two  of  these  basic  forms — sole  proprietorship  and 
partnership — represent  the  personal  relationship  of  a  man  or 
a  group  of  men  to  the  business;  but  the  third  form,  which 
is  a  comparatively  modern  invention,  separates  the  owner  or 

II 


12  FINANCE  AND   BUSINESS   ORGANIZATION 

owners  from  the  business  and  brings  into  being  an  impersonal,  J 
intangible  thing — a  corporation — in  which  the  nominal  owner-  ^ 
ship  is  vested. 

It  has  been  pointed  out  by  writers  on  economics  that  there 
are  three  elements  that  must  be  distributed  under  any  form  of 
ownership;  these  three  elements  are  risk,  income,  and  man- 
agement. In  the  individual  proprietorship  the  three  are  cen^ 
tered  in  one  man  who  risks  his  own  capital,  undertakes  the 
management,  and  receives  all  the  income.  Under  the  partner- 
ship form,  the  partners  as  a  body,  like  the  individual  owner, 
undertake  the  risk  and  management  and  receive  the  income; 
but  among  themselves  there  may  be  an  infinite  number  of 
combinations.  One  partner,  for  instance,  may  supply  all  of 
the  capital;  another  may  supply  the  management;  and  they 
may  divide  the  income  in  any  manner  agreed  upon.  Under 
the  corporate  form  the  risk  is  taken  by  the  various  creditors 
and  shareholders  who  supply  capital  under  the  conditions  that 
have  been  agreed  upon.  These  creditors  and  shareholders 
divide  the  income  in  rough  proportion  to  their  risk.  The 
management,  however,  is  not  necessarily  retained  in  the 
hands  of  the  people  who  contribute  the  capital,  but  may  be 
turned  over  to  directors  and  officers  who  are  not  personally 
large  shareholders.  The  tendency  has  plainly  been  to  separate 
the  supplying  of  capital  for  the  business  and  the  management 
of  the  capital  so  that  they  need  not  necessarily  be  joined  in 
one  man  or  even  in  a  small  group  of  men. 

Sole  Proprietorship 

The  first  of  the  three  basic  forms  of  business  organization 
— the  sole  proprietorship — is  the  simplest  and  is  even  yet  the 
most  numerous.  Small  shops,  farms,  professional  activities, 
and  the  like,  are  usually  owned  and  conducted  by  one  man. 
The  owner  does  not  separate  his  ownership  of  the  business 
from  his  management  of  it;  he  does  not  even  separate  the 


FORMS   OF   BUSINESS   ENTERPRISES  1 3 

ordinary  management  of  his  business  affairs  and  the  manage- 
ment of  his  personal  affairs.  He,  himself,  is  the  business  and 
the  business  is  a  part  of  him. 

The  simplicity  of  this  form  does  not  necessarily  imply, 
however,  that  it  is  applicable  only  to  a  small  business.  Many 
men  of  great  wealth  could  properly  regard  the  investment  and 
management  of  their  funds  as  itself  a  business,  for  this  work 
alone  sometimes  requires  the  services  of  a  force  of  assistants, 
bookkeepers,  and  clerks.  Then,  again,  an  individual  may 
embark  upon  a  business  enterprise  which  grows  rapidly  from 
year  to  year  and  becomes  very  extensive;  yet  the  original 
proprietor  may  continue  to  own  and  direct  it  all.  This  was 
the  case,  for  instance,  up  to  a  few  years  ago  with  the  great 
department  stores  in  Philadelphia  and  New  York  which  were 
personally  owned  and  managed  by  Mr.  John  Wanamaker. 
However,  it  usually  happens  that  a  business  which  is  becom- 
ing large  and  prosperous  finds  the  single  proprietorship  un- 
desirable. 

The  sole  proprietorship  has  a  real  advantage  in  the  ease 
with  which  a  business  may  be  started  in  this  form,  and  a 
slight  economy  due  to  the  absence  of  all  legal  agreements.  A 
forceful  man  can  often,  by  reason  of  his  freedom  from  any 
restraint,  make  rapid  growth  under  this  form.  A  young  man 
who  starts  his  own  business  in  his  own  name  learns  business 
management  as  the  business  grows,  masters  the  difficulties  of 
financial  problems  as  he  solves  them,  and  becomes  an  all-round 
business  man,  with  initiative,  ability,  and  resourcefulness,  by 
the  natural  evolution  incident  to  his  situation.  Many  of  the 
biggest  businesses  and  very  many  of  the  biggest  business  men 
in  this  country  have  developed  along  the  lines  of  sole  pro- 
prietorship. 

Its  chief  disadvantages  are  three  in  number.     First,  the 

capital  of  the  businps<^  is  limitprl  tn  wliqtf>vpi:-tkp  OAynpr  pn«;, 

sesses  or  can  borrow.    Some  kinds  of  businesses,  if  they  grow 


14  FINANCE   AND   BUSINESS    ORGANIZATION 

at  all,  will  finance  themselves,  so  that  there  will  never  be  need 
for  any  more  capital  than  was  devoted  to  the  business  at 
the  start;  but  the  great  majority  of  business  concerns  which 
are  expanding  require  fresh  capital. 

A  second  and  even  more  serious  disadvantage  is  the  strict 
a ,  limitation  on  the  management  of  the  business.  The  owner 
must  depend  for  all  executive  work  either  solely  upon  his  own 
efforts  or  in  part  upon  the  efforts  of  men  whom  he  engages 
at  a  fixed  salary.  Men  of  real  executive  ability  ordinarily 
prefer  to  go  with  concerns  in  which  they  themselves  have  an 
interest  in  the  business.  If  the  individual  owner  wishes  to 
secure  the  services  of  these  men,  the  salaries  he  pays  must 
be  exceptionally  high.  To  refer  again  to  the  case  of  John 
Wanamaker,  it  is  reported  that  when  he  was  getting  started 
in  Philadelphia,  there  were  at  least  a  dozen  of  his  employees 
who  were  drawing  much  larger  incomes  from  the  business 
than  was  the  proprietor  himself. 

The  third  disadvantage,  as  compared  at  least  with  the 
corporation,  is  the  ever-present  personal  liability  of  the  owner 
for  all  the  debts  of  his  business.  He  cannot  legally  separate 
his  personal  property  from  that  devoted  to  his  business. 

The  Partnership 

Fundamentally,  there  is  no  essential  difference  between  the 
sole  proprietorship  and  the  partnership,  except  that  in  the 
second  case  a  group  of  owners  take  the  place  of  the  individual 
owner.  There  may  be  any  number  of  partners  and  among 
themselves  they  may  have  many  different  forms  of  agreement. 
The  agreement  must  be,  of  course,  between  parties  competent 
to  contract.  Partners  are  not  necessarily  equal,  by  any  means, 
in  respect  to  their  investment  of  capital  or  as  to  their  division 
of  the  income.  Sometimes  one  partner  receives  a  larger  pro- 
portion of  the  income  than  corresponds  to  his  investment  of 
capital  in  order  to  compensate  him  for  a  special  contribution 


FORMS   OF  BUSINESS   ENTERPRISES 


15 


that  he  may  be  in  position  to  make  to  the  business,  such  as 
valuable  experience  or  connections,  or  unusual  business  ability. 
A  partner  may  not  desire  to  have  much  capital  in  the  business 
or  even  to  be  known  as  in  any  way  interested,  in  which  case 
he  may  by  agreement  become  a  "dormant"  or  "sleeping" 
partner.  Again,  he  may  desire  to  limit  his  own  liability  to  the 
amount  which  he  invests,  in  which  case  he  may  become  a 
"limited"  partner. 

There  are  certain  forms  of  partnerships  which  are  used 
for  special  or  temporary  purposes,  such  as  the  "syndicate," 
the  "joint  adventure,"  etc.,  but  these  are  details  that  involve ' 
Vs  in  many  technical  questions  and  lead  us  outside  the  scop^ 
of  this  volume.  In  all  these  various  forms,  however,  the- 
personal  relationship  of  the  owner  of  the  capital  to  the  man- 
agement of  the  business  is  a  strong  element.  It  may  be  hidden 
or  modified  in  part,  but  it  is  never  absent. 

Because  of  the  personal  element  involved,  the  partnership! 
is  regarded  as  the  proper  form  in  which  to  organize  such 
professional  activities  as  those  of  lawyers,  accountants,  and 
engineers.  In  all  these  cases  it  may  be  necessary  to  bring  to- 
gether in  one  organization  considerable  capital  and  the  talents 
of  many  different  men.  The  product  of  this  organization, 
however,  is  not  some  material  thing,  but  a  direct  personal 
service ;  hence,  the  personal  liability  and  personal  relationship, 
which  are  characteristic  of  the  partnership  form,  are  desirable 
and  should  be  retained.  There  are  other  lines  of  business  in 
which  it  is  desired  to  avoid  the  legal  regulation  which  is  ap- 
plied to  corporations,  and  for  this  reason  the  partnership  form 
is  preferred.  This  is  particularly  true  of  the  banking  business. 
Most  concerns  engaged  in  buying  and  selling  securities,  in 
underwriting,  and  the  like,  are  not  incorporated,  but  are  or- 
ganized as  partnerships.  There  are  a  few  large  trading  and 
manufacturing  enterprises  in  the  partnership  form.  Until 
recently,   Arbuckle   Brothers   and  the   Baldwin   Locomotive 


l6  FINANCE  AND   BUSINESS   ORGANIZATION 

Works  were  still  conducted  as  partnerships,  and  this  is  even 
yet  true  of  Rogers,  Peet  and  Company,  of  New  York. 

Disadvantages  of  the  Partnership 

Of  the  three  disadvantages  applicable  to  the  individual 
proprietorship,  only  one  does  not  apply  to  the  partnership. 
There  is  very  little  difficulty  under  the  partnership  form  in 
attracting  high-priced  business  talent.  On  the  contrary,  in 
this  one  respect  the  partnership  is  probably  superior  to  both 
the  other  basic  forms  of  enterprise.  The  other  two  disad- 
vantages of  individual  proprietorship — the  limitation  on  com- 
mand of  capital  and  the  personal  liability  for  all  business 
obligations — are,  however,  shared  by  the  partnership. 

By  reason  of  the  personal  character  of  the  relationship 
between  each  of  the  owners  and  the  business,  it  is  highly  un- 
desirable that  anyone  should  be  included  in  a  partnership  un- 
less he  is  personally  acceptable  and  able.  As  all  of  the  part- 
ners, except  dormant  or  limited  partners,  have  equal  rights 
in  the  control  of  the  business,  and  as  any  one  of  them  may 
bind  the  entire  firm  by  his  acts  or  contracts,  the  consequences 
of  bringing  in  an  incompetent  partner  may  easily  be  very 
serious.  As  compared  with  a  corporation,  this  introduces  a 
serious  handicap  in  searching  for  fresh  capital  with  which  to 
y  develop  the  business.  It  is  necessary  not  merely  to  find  one 
man  with  capital  and  another  man  with  brains  to  help  manage 
it,  but  to  find  one  man  who  has  both  the  capital  and  the  brains, 
who  is  at  the  same  time^jzwHing  to  devote  time,  money,  and 
thought  to  the  enterprise,  and  whose  personality  is  such  as 
to  insure  harmonious  relations  with  the  existing  partners. 
^'  The  other  disadvantage,  namely,  the  personal  liability  of 
each  part  owner,  is  even  more  serious  in  the  partnership  than 
in  the  sole  proprietorship.  In  the  case  of  the  individual  pro- 
prietor, he  can  suffer  only  through  his  own  misfortunes  or 
errors;  the  partner,  however,  may  suddenly  find  himself  face] 


FORMS   OF   BUSINESS   ENTERPRISES 


17 


to  face  with  heavy  loss  due  to  the  bad  fortune  or  errors  of  any 
of  his  partners.  His  own  personal  property  (except  under 
one  of  the  special  forms  of  agreement  above  referred  to) 
belongs  to  the  business  and  to  the  creditors  of  the  business 
until  the  last  debt  has  been  paid.  If  one  of  his  partners  proves 
dishonest  or  treacherous,  he  may  be  called  upon  to  foot  the 
bill — and  not  merely  to  the  extent  of  his  previous  investment 
in  the  business,  but  to  the  extent  of  all  of  his  personal  holdings. 
It  is  for  this  reason  that  a  partnership  agreement  is  so  weighty 
a  matter.  Moreover,  on  the  death  or  withdrawal  of  any  of 
the  partners,  if  an  agreement  cannot  be  reached  with  the  retir- 
ing partner  or  with  the  estate,  it  may  be  necessary  to  go 
through  all  the  trouble  of  suit  in  equity  for  an  accounting  and 
wind  up  the  business. 

In  the  face  of  these  disadvantages  it  is  not  surprising  that 
very  few  business  concerns,  outside  the  special  classes  men- 
tioned, have  retained  the  partnership  form.  It  is  becoming 
every  year  relatively  of  less  and  less  consequence. 

The  Corporation 

The  corporation  is  quite  distinct  from  the  sole  proprietor- 
ship and  the  partnership.  The  capital  is  supplied  by  a  small 
or  large  group  of  people  called  shareholders,  or  stockholders. 
The  business  is  usually  managed  by  a  group  of  officers  and 
directors  elected  by  the  shareholders.  The  shareholders  have 
no  liability  for  the  debts  of  the  corporation  beyond  the  amount 
which  they  have  contributed  as  capital.  Owing  to  the  possi- 
bility of  dividing  the  capital  up  into  shares  of  comparatively 
small  amount,  funds  may  be  raised  from  the  general  public 
by  putting  these  shares  on  the  market;  and  it  is  much  easier 
to  finance  a  business  of  great  magnitude  in  this  way  than 
through  either  individual  ownership  or  through  a  partnership, 
in  which  there  are  necessarily  only  a  limited  number  of  people. 

The  business  is  thus  managed  by  only  a  part  of  the  people 


l8  FINANCE   AND   BUSINESS    ORGANIZATION 

*  who  supply  the  capital.  The  corporation  Itself  is  regarded  as 
a  distinct  and  separate  entity,  capable  of  doing  business  by 
itself;  the  corporation  may  sue,  may  be  sued  by,  and  may 
contract  with  Its  own  members,  as  well  as  with  outsiders.  The 
officers  and  directors  conduct  these  operations  In  the  corporate 
name. 

^  The  corporate  form  is  used  for  social  arid  governmental, 
as  well  as  for  business,  organizations.  Towns,  villages,  and 
cities  are  conducted  as  corporations.  Corporations  for  govern- 
mental purposes  are  called  public .  corporations ;  corporations 
for  business  and  social  purposes,  private  corporations. 
—  Religious,  educational,  charitable,  and  social  organizations 
are  usually  incorporated  without  capital  stock  and  are  known 
as  membership  corporations.  When  corporate  action  is  taken, 
each  member  has  one  vote  and  no  more.  Mutual  insurance 
companies  and  stock  exchanges  are  among  the  more  important 
of  the  non-stock  corporations. 

All  corporations  to  conduct  business  for  profit  have  a 
capital  stock  divided  into  shares,  usually  of  like  amount,  which 
are  evidenced  by  transferable  certificates  of  stock.  The 
holders  of  these  certificates  are  termed  stockholders.  Each 
share  of  stock  usually  entitles  its  owner  to  one  vote  in  stock- 
holders* meetings,  and  a  majority  of  the  shares  elect  the 
directors  and  control  the  policy  of  the  company.  When  profits 
are  to  be  divided,  they  are  distributed  among  the  stockholders 
in  proportion  to  the  number  of  shares  they  own. 

Limited  Partnerships 

In  an  effort  to  overcome  the  disadvantages  incident  to  the 
partnership  relation,  many  enterprises,  especially  in  Great 
Britain  and  the  British  colonies,  have  been  organized  as  "joint- 
stock''  companies,  which  may  be  briefly  defined  as  a  form  of 
limited  partnership.  In  the  United  States,  as  we  shall  see, 
this  movement,  though  of  some  importance,  has  not  gone 


FORMS   OF   BUSINESS   ENTERPRISES 


19 


very  far  because  of  the  superior  advantages  of  the  corporate 
form. 

A  limited  partnership  may  only  be  formed  under  special 
laws.  It  differs  from  an  ordinary  partnership  in  that  one 
or  more  of  its  partners  are  silent  or  inactive;  they  share  in 
the  profits  but  take  no  part  in  the  management  of  the  business. 
The  liability  of  these  partners  is  limited  to  the  amount  actually 
invested  by  them  in  the  business.  These  partners  whose 
liability  is  limited  are  called  special  partners  in  contradistinc- 
tion to  th^jgher  general  partners.  To  secure  this  restricted 
liability  it^Biecessary  to  -comply  closely  with  the  statutory 
provisions.  The  procedure  necessary  to  form  a  limited  part- 
nership is  almost  as  formal  as  me  incorporation  of  aj^ock 
company,  and  failure  to  observe  the  required  formalitie^may 
result  in  making  the  special  partners  liable  as  general  partners. 
Sometimes  it  is  attempted  to  secure  the  benefits  of  this  limited 
liability  without  complying  with  the  state  law.  In  such  case, 
the  individual  who  invests  his  money  keeps  the  matter  secret 
and  is  known  as  a  dormant  or  "sleeping**  partner.  If  the 
arrangement  is  discovered,  he  would  be  liable  in  exactly  the 
same  way  and  to  the  same  extent  as  an  active  partner. 

Joint-Stock  ComjJdbies 

A  joint-stock  company  is  a  partnership  with  its  capital 
divided  into  transferable  shares.  Except  in  the  State  of  New 
York,  such  a  company  may  be  formed  simply  by  agreement. 
In  New  York  special  statutes  provide  for  an  organization 
similar  to  a  corporation,  and  the  formation  of  such  associa- 
tions is  prohibited  except  as  provided  by  the  statutes.  The 
courts  in  New  York  define  these  organizations  as  being  part- 
nerships with  some  of  the  powers  of  a  corporation.  In  New 
York  these  joint-stock  companies  may  sue  or  be  sued  in  the 
name  of  the  president  or  treasurer,  and  the  individual  mem- 
bers may  not  be  sued  until  it  is  shown  that  the  claim  cannot 


n 


20  FINANCE  AND   BUSINESS   ORGANIZATION 

be  collected  from  the  company.  Several  of  the  leading  express 
companies  are  organized  under  the  New  York  Joint-Stock 
Company  Law,  and  in  these  cases  the  arrangement  seems  to 
work  very  satisfactorily.  In  other  states  the  joint-stock  com- 
pany form  is  very  rarely  used  for  the  following  reasons: 

1.  Members  of  the  company  are  individually  liable  for 

its  entire  obligations. 

2.  While  the  company  can  do  business  under  its  company 

name,  it  cannot  hold  real  estate  and  it  is  necessary 
that  any  real  property  be  held  by  some  agent  or 
officer  as  trustee  for  the  company. 

3.  The  joint-stock  company  must  bring  suit  in  the  names 

of  all  the  members,  and,  if  it  is  sufrd,  only  those 
members  who  are  served  with  process  can  be  held. 

There  are  cases  where  the  danger  of  partnership  liability 
is  too  remote  to  trouble  the  members,  and  in  such  cases  the 
joint-stock  company  secures  the  same  advantage  of  stock  and 
transferable  stock  certificates  as  does  the  corporation.  The 
form  could  not  be  used  where  stock  is  to  be  sold  to  investors 
as  these  would  not  risk  the  partnership  liability  involved. 
Practically,  the  joint-stock  organization  is  rarely  used  in  this 
country.  In  Great  Britain  and  the  British  colonies,  it  is  quite 
common.  From  a  financial  standpoint  the  British  joint-stock 
company  is  practically  the  same  as  the  American  corporation. 
The  words  "company"  or  "corporation"  will  hereafter  be  used 
interchangeably  and  refer  to  either. 

Associations  Under  Deeds  of  Trust 

Various  experiments  have  been  tried  at  different  times  in 
the  way  of  carrying  on  business  through  trustees.  It  was 
long  ago  decided  in  England  that  the  actual  owners  of  the 
property  could  not  be  held  liable  as  partners  if  the  property 
was  in  trust  and  the  business  carried  on  by  trustees. 


FORMS    OF   BUSINESS    ENTERPRISES  21 

The  Standard  Oil  Company,  the  Sugar  Trust,  and  the 
Bay  State  Gas  Company  in  this  country  were  all  organized 
as  trusts.  A  board  of  trustees  took  over  the  stock  of  the 
constituent  companies  and  issued  trust  certificates  to  the 
owners.  Thereafter,  until  the  courts  declared  such  organiza- 
tions illegal,  these  boards  of  trustees  dominated  their  respec- 
tive industries.  The  courts  decided  that  trusts  of  this  nature 
were  illegal,  not  because  of  any  objection  to  their  form  of 
organization,  but  because  their  chief  object  was  to  restrict 
competition. 

When  the  trust  form  was  forbidden  to  these  monopolies, 
they  resorted  to  the  holding  corporation,  but  the  name  ''trust" 
persisted  and  is  still  used  to  designate  the  great  monopolistic 
corporations.  It  is  misleading  and  has  caused  considerable 
unjust  prejudice  on  the  part  of  the  public  against  this  method 
of  doing  business. 

The  trust  form  of  business  association  is  used  to  a  limited 
extent  in  Massachusetts.  Up  to  19 12  the  law  in  that  state 
made  no  provision  for  corporations  to  deal  in  real  estate,  and 
consequently  a  large  number  of  real  estate  trusts  under  the 
name  of  "voluntary  associations"  came  into  existence.  They 
have  increased  until  they  now  own  not  less  than  $250,000,000 
in  real  property.  Of  late  years  this  form  of  organization  has 
extended  to  a  limited  degree  into  other  lines  of  business 
activity  and  may  become  a  popular  form. 

The  characteristic  features  of  these  voluntary  associations 
are  as  follows: 

1.  A  deed  or  declaration  of  trust,  drawn  up  to  define  the 

rights  and  powers  of  the  trustees  and  the  share- 
holders. 

2.  Two  or  more  trustees  who  are  authorized  to  take 

over  and  manage  the  capital,  business,  or  property 
supplied  by  the  shareholders. 


ii 


22  FINANCE  AND   BUSINESS    ORGANIZATION 

3.  Shareholders    who    receive    transferable    certificates 

representing  their  respective  interests  in  the  profits 
and  in  the  property  on  dissolution. 

4.  Provisions   for  division  of  profits,   appointment  of 

trustees  to  fill  vacancies,   and   for  dissolution  at 
termination  of  the  trust. 

It  is  usual  to  provide  in  the  deed  of  trust  that  no  liability 
is  to  attach  to  the  shareholders  or  trustees. 

The  Commissioner  of  Corporations  of  Massachusetts  in 
closing  his  report  summarizes  the  advantages  afforded  by 
these  voluntary  associations  as  follows:* 

1.  The  experience  of  twenty-five  years  shows  that  they  furnish 

a  convenient,  safe,  and  unobjectionable  form  of  co-opera- 
tion, ownership,  and  management. 

2.  Their  form  of  management  is  more  flexible,  more  economi- 

cal, and  more  convenient  than  that  of  a  corporation.  Trus- 
tees can  do  business  with  more  ease  and  rapidity  than  a 
board  of  directors. 

3.  In  particular  they  afford  a  convenient  form  for  combining 

capital  for  the  development  and  improvement  of  real 
estate,  as  the  form  of  organization  insures  a  continuity 
of  management  and  control  that  specially  appeals  to  inves- 
tors in  real  estate,  and  which  cannot  be  secured  by  a 
corporation  on  account  of  the  change  of  officers  each 
year.  Trustees  are  not  changed  as  frequently  as  are 
directors  of  a  corporation. 

Business  Organization  Under  the  Latin  Law 

The  principal  forms  of  business  associations  in  France 
are:  (i)  the  ordinary  partnership  with  a  firm  name  (societe 
en  nont  collectif) ;  (2)  the  limited  partnership  {societe  en 
commandite) ;  (3)  the  joint-stock  company  {societe  anonyme). 

The  partnership  is  much  the  same  as  under  English  and 

*Report  of  Massachusetts  Tax  Commissioners  upon  Voluntary  Associations. 
January  17,  1912.  See  also  Sears  on  "Effective  Substitutes  for  Incorporation,"  and 
Chanler   on    "Express   Trusts." 


FORMS   OF   BUSINESS   ENTERPRISES  23 

American  law  except  that  the  personal  element  is  even  more 
strongly  accentuated ;  for  instance,  it  would  be  fraud  to  insert 
in  the  name  of  the  firm  the  proper  names  of  any  persons  not 
actually  connected  with  the  firm.  The  partners  are  considered 
to  have  given  each  other  the  right  to  manage  one  for  the 
other,  and  to  bind  the  firm  by  their  signatures. 

The  so-called  societe  anonyme  resembles  the  English  joint- 
stock  company  more  closely  than  the  American  corporation. 
The  separate  existence  of  the  association,  apart  from  the 
individuals  who  make  it  up,  is  not  so  much  insisted  upon 
as  in  this  country.  The  directors  must  be  chosen  from  among 
the  shareholders.  In  France  the  directors  must  draw  up  a 
brief  statement  every  half-year  showing  the  condition  of  the 
company  as  regards  assets  and  liabilities.  In  all  corporations 
it  is  necessary  to  deduct  not  less  than  5%  from  the  net  profits 
of  each  year  for  the  purpose  of  forming  a  reserve,  fund.  This 
deduction  need  not  be  continued  after  the  reserve  fund  has 
come  to  exceed  10%  of  the  capital  of  the  company. 

In  general,  without  attempting  to  enter  into  legal  techni- 
calities, the  customary  character  of  business  associations  is 
the  same  throughout  the  Latin  countries,  including  France, 
Spain,  Portugal,  Italy,  Belgium,  and  practically  all  of  South 
America.  In  all  these  countries  the  societe  anonyme  is  the 
form  of  association  which  corresponds  to  our  corporation  or 
joint-stock  company. 

Business  Organization  Under  the  German  Law 

There  are  various  forms  of  associations  under  German 
law  of  which  the  stock  company  (Aktiengesellschaft),  and  the 
limited  liability  company  {Gesellschaft  mit  beschrdnkter  Haf- 
tung,  usually  abbreviated  m.h.H.)  are  the  two  most  popular 
forms. 

The  stock  company  may  be  regarded  as,  for  most  practical 
purposes,  equivalent  to  a  corporation  or  joint-stock  company 


24  FINANCE  AND   BUSINESS   ORGANIZATION 

under  English  and  American  law.  It  usually  has  both  a  board 
of  directors  (Vorstand)  and  a  board  of  managers  (Auf- 
sichtsrat),  but  does  not  necessarily  possess  a  president,  secre- 
tary, and  treasurer.  Executive  power,  in  other  words,  is 
lodged  in  the  board  and  not  in  individual  officers. 

The  German  limited  liability  company  has  been  described  as 
a  cross  between  an  American  corporation  and  a  partnership. 
"In  contemplation  of  German  law,  it  is  an  artificial  person 
or  jiiristische  Person,  and  has  an  existence  of  its  own  separate 
and  distinct  from  that  of  its  founders  and  shareholders;  and 
is  therefore  a  body  corporate.  This  corporate  form  is  much 
simpler  than  the  Aktiengesellschaft  or  stock  company.  Its 
capital  is  not  divided  into  shares  and  no  certificates  of  stock 
are  issued.  Individual  interests  or  holdings  in  the  company 
may  be  transferred  in  whole  or  in  part  by  notarial  or  judiciary 
act.* 

This  form  of  association  is  used  chiefly  for  small  com- 
panies in  which  only  a  few  persons  are  interested.  The  man- 
agement is  usually  determined  by  agreement  among  the 
various  persons  interested,  much  as  in  an  ordinary  partner- 
ship, though  in  the  larger  companies  of  this  type  there  may 
be  a  board  of  control. 


*Ref>ort  on  the  Commercial  Laws  of  England,  Scotland,  Germany,  and  France, 
by  Archibald  J.  Wolfe  in  collaboration  with  Edwin  M.  Borchard,  issued  by  the  Bureau 
of  Foreign  and  Domestic  Commerce,  Washington,  D.  C,  1915.  Much  of  the  informa- 
tion contained  in  the  preceding  section  also  is  abstracted  from  this  report. 


CHAPTER    III 

THE    CORPORATION 

Origin  of  Corporations 

The  modern  corporation  did  not  suddenly  spring  into  being 
as  a  device  for  overcoming  the  obstacles  of  previous  forms 
of  business  enterprises.  It  has  been  slowly  and  painfully 
developing  for  centuries,  and  in  its  present  form  is  a  com- 
posite of  the  ideas  and  the  experience  of  many  different  races 
and  generations  of  men. 

On  one  side,  the  business  corporation  is  closely  related 
to  the  municipal  and  religious  corporation.  The  jurists  of  the 
early  middle  ages  conceived — or  rathrir  adapted  from  Roman 
law — the  idea  of  the  church  as  a  legal  entity,  distinct  from 
any  of  its  officers  or  ministers.  It  was  clear  that  the  endow- 
ments, for  instance,  which  were  given  to  bishops  and  abbots 
were  not  intended  for  their  personal  enjoyment  nor  to  be 
disposed  of  as  they  saw  fit.  It  was  desirable  that  the  funds 
should  be  entrusted  to  an  owner  that  would  exist  year  after 
year  and  generation  after  generation,  irrespective  of  human 
frailties  or  vicissitudes.  Out  of  this  need  for  permanence 
and  for  impersonality  in  holding  religious  property,  grew  the 
perfected  idea  of  the  church  itself  and  of  other  religious  and 
charitable  organizations  existing  as  separate  entities  or  "cor- 
porations." It  was  an  easy  step,  when  a  similar  need  arose 
in  business  undertakings,  to  transfer  this  conception  from  re- 
ligious organizations  to  business  organizations. 

During  the  last  three  centuries,  the  corporation  has  grown, 
both  in  Europe  and  in  the  United  States,  along  parallel  lines 
of  development.  The  result  attained  is  not  exactly  the  same, 
for  there  are  many  technical  points  of  difference  between  the 

25 


26  FINANCE  AND   BUSINESS   ORGANIZATION 

German  Gesellschaft  mit  beschrdnkter  Haftung,  the  French 
societe  anonyme,  the  English  "joint-stock  company"  and  the 
American  "corporation,"  but  these  points  of  difference  are 
of  no  great  importance  compared  with  the  central  fact  that 
in  all  these,  and  in  all  other  commercial  countries  as  well,  there 
has  come  to  exist  a  certain  type  of  business  association,  the 
essential  features  of  which  are: 

1.  Little  or  no  direct  personal  relation  among  proprietors 

or  between  the  proprietors  and  the  business;  such 
relations  as  do  exist  are  on  the  impersonal  basis 
of  capital  invested. 

2.  Control  and  management  by  elected  representatives 

acting  in  trust  for  the  proprietors. 

3.  Liability  of  proprietors  limited  to  their  Investment  or 

to  some  fixed  amount  proportioned  to  their  invest- 
ment. 

Fiction  of  Corporate  Entity 

Both  the  Continental  courts  and  the  English  courts  have 
tended  always  to  regard  the  corporation  or  company  as  if  it 
were  a  group  of  individuals,  while  in  this  country  the  tendency 
has  been  to  follow  strictly  Chief  Justice  Marshall's  famous 
definition  in  the  Dartmouth  College  case  in  18 19,  wherein  he 
spoke  of  the  corporation  as  "an^artificial  being,  invisible^  iit- 
tangible,  and  existing  only  in  contemplation  of  the  law."  The 
logical  simplicity  of  this  view  appeals  strongly  to  the  legal 
mind,  and  many  beautiful  bits  of  fine-spun  reasoning  based 
upon  it  are  to  be  found  in  the  records  of  our  courts.  But 
unfortunately,  it  happens  to  be  far  removed  from  the  facts  of 
every-day  business  life.  We  all  know  that  in  practice  the 
corporation  has  no  existence  and  no  interests  apart  from  the 
existence  and  interests  of  its  shareholders,  creditors,  and  of- 
ficers.    In  an  ideal  world,  possibly,  men  would  devote  them- 


THE   CORPORATION  27 

selves  to  building  up  a  business  corporation  for  its  own  sake, 
just  as  many  men  have  devoted  themselves  to  building  up 
religious  and  governmental  corporations,  and  in  that  case  there 
would  be  some  solid  basis  for  the  lawyer's  line  of  reasoning. 
However,  in  our  work-a-day  world,  the  reverse  is  more  often 
true ;  the  corporation  may  easily  prove  a  convenient  shield  for 
the  men  back  of  it  who  are  intent  upon  actions  and  policies 
for  which  they  would  not  care  to  accept,  as  individuals,  the 
full  responsibility. 

The  fiction  of  corporate  entity  favors  this  species  of  mis- 
use. It  erects  an  obstacle — an  ^'invisible,  intangible,"  but  ef- 
fective obstacle — between  the  wrongdoer  and  his  victim. 

Recognizing  this  abuse,  the  courts  of  this  country  have 
become  more  and  more  inclined  in  recent  years  to  tear  aside 
the  corporate  mask  and  look  for  the  men  and  the  motives 
behind  corporate  actions.  This  is  true  at  least  of  courts  of 
equity.  Nevertheless,  we  are  still  tangled  and  blocked  at  every 
step  by  the  thousands  of  precedents  consisting  of  decisions 
based  upon  the  fundamental  idea  of  the  corporation  as  a  thing 
distinct  from  the  men  who  compose  it. 

Grant  of  Powers  by  the  State 

The  powers  of  a  corporation  are  derived  from  the  charter 
granted  it  by  the  state  and  these  powers  are  limited  by  the 
law  in  some  respects.  A  corporation  has  no  power  to  do  any- 
thing not  expressly  mentioned  in  its  charter  or  necessary  to 
carry  out  some  purpose  which  is  expressly  mentioned  by  its 
charter. 

Before  the  general  incorporation  acts  were  passed,  the 
corporation  had  to  secure  its  life  and  its  grant  of  powers  by 
special  application  and  special  act  of  the  legislative  or  sovereign 
authority.  Since  then,  the  application  has  become  a  matter 
of  form  only.  There  is  no  discretion  in  the  executive 
authority  to  refuse  any  request  for  a  charter  which  conforms 


28  FINANCE   AND   BUSINESS    ORGANIZATION 

to  a  few  set  forms  and  regulations.  Any  citizen  has  as  much 
right  as  any  other  to  organize  a  corporation  without  asking 
a  favor  from  any  man  or  any  governmental  body. 

Special  Charters 

Special  charters  are  still  sometimes  applied  for  and  ob- 
tained, but  they  are  not  in  high  favor  for  several  reasons. 
First,  of  all,  it  frequently  requires  political  influence  and  pres- 
sure to  secure  them;  second,  unless  there  are  some  marked 
peculiarities  of  the  law,  there  is  ordinarily  no  reason  to  prefer 
a  special  charter  over  the  ordinary  charter  obtained  under  a 
general  enabling  act;  third,  a  special  charter  is  always  more 
or  less  an  uncertain  thing  because  it  has  not  been  given 
authoritative  interpretation  by  the  courts,  whereas  the  charter 
obtained  under  a  general  act  can  be  framed  with  an  eye  to 
previous  decisions  and  can  thus  be  cleared  of  unexpected  legal 
pitfalls. 

A  feature  of  public  utility  corporations  in  Great  Britain 
is  the  fact  that  each  company  is  organized  and  governed  by 
a  special  act.  These  acts,  however,  are  to  a  considerable 
extent  standardized  through  uniform  clauses  and  model  forms 
that  have  been  adopted  by  the  Board  of  Trade.  In  general, 
any  company  in  Great  Britain  which  exercises  rights  of  emi- 
nent domain  or  other  exceptional  rights  is  likely  to  ask  for  a 
special  charter.  However,  numerous  small  gas  and  water 
companies  and  other  public  utilities  are  operated  without 
special  parliamentary  authority,  and  are  chartered  under  the 
general  enabling  law  known  as  the  ''Companies  Consolidation 
Act"  of  1908. 

An  ordinary  charter  in  the  United  States  is  in  the  form 
of  an  application  to  the  Secretary  of  State  or  other  proper 
authority  for  permission  to  incorporate ;  as  soon  as  a  govern- 
mental official  has  received,  approved,  and  filed  this  applica- 
tion, it  becomes  the  charter — we  might  call  it  the  constitution 


i 


THE   CORPORATION  29 

— of  the  corporation.     The  information  which  it  contains  is 
usually  the  following: 

1.  The  name  of  the  corporation. 

2.  The  purposes  for  which  it  is  formed. 

3.  The  amount  and  classes  of  corporate  stock. 

4.  The  location  of  the  principal  business  office. 

5.  The  period  of  existence  of  the  corporation  which  is 

usually  unlimited  or  perpetual. 

6.  The  names  and  addresses  of  the  incorporators. 

The  Corporate  Name 

It  is  provided  in  several  states  that  the  corporate  name 
must  include  the  word  ''Company"  or  must  be  followed  by 
some  such  word  as  "Incorporated"  or  "Limited,"  the  purpose 
being  to  show  in  the  title  itself  that  the  enterprise  is  incor- 
porated. It  is  in  most  states  forbidden  to  take  a  name  which 
has  been  already  utilized  by  some  previously  existing  corpora- 
tion, or  to  take  a  name  which  is  so  close  as  to  be  misleading. 
Corporations  which  have  acquired  a  great  deal  of  good- will 
value  in  connection  with  their  names,  depend,  however,  chiefly 
upon  the  common  or  statutory  laws  against  unfair  competition 
to  protect  them  against  imitation  or  misuse  of  their  names. 

The  Corporate  Purposes 

The  purpose  for  which  a  corporation  is  formed  should  be 
fully  and  clearly  stated;  it  is  customary  to  add  one  or  two 
paragraphs  of  a  general  nature  which  give  the  corporation 
power  "to  do  any  and  all  other  acts  and  things  and  to  exercise 
any  and  all  other  powers  which  a  copartnership  or  natural 
person  could  do  and  exercise  and  which  now  or  hereafter  may 
be  authorized  by  law."  It  is  not  always  convenient,  although 
there  are  usually  no  legal  difficulties,  to  amend  the  statement 
of  purposes  in  a  charter;  for  this  reason  liberality  and  fulness 
in  stating  them  in  the  first  place  are  desirable.    A  great  many 


30 


FINANCE  AND   BUSINESS   ORGANIZATION 


useful  forms  for  stating  the  purposes  of  corporations  engaged . 
in  various  lines  of  business  are  easily  available  through  the 
standard  legal  manuals. 

Classes  of  Stock 

The  statement  as  to  the  amount  and  nature  of  the  various 
classes  of  stock  is  a  section  of  the  charter  which  is  customarily 
amended  from  time  to  time  in  case  changes  in  the  company's 
capitaHzation  are  made.  Sometimes  the  original  statement 
is  intended  simply  as  a  "blind."  For  instance,  the  certificate 
of  incorporation  of  the  United  States  Steel  Corporation 
which  was  filed  in  the  office  of  the  Secretary  of  State  of  New 
Jersey  on  February  23,  1901,  showed  a  capitalization  of 
$3,000.  On  April  i,  1901  the  certificate  was  amended  and 
the  capitalization  was  changed  to  $1,100,000,000 — one-half 
common  and  one-half  preferred. 

The  Principal  Business  Office 

The  principal  business  office  is  not  necessarily  the  office  at 
which  most  of  the  business  of  the  corporation  is  transacted, 
but  is  the  office  at  which  legal  papers  may  be  served  and 
certain  legal  business  transacted.  Many  of  the  large  corpora- 
tions of  the  United  States  having  their  headquarters  in  New 
York,  are  incorporated  in  New  Jersey,  Delaware,  or  some 
other  state.  In  that  case  their  "principal  business  office"  is 
likely  to  consist  of  a  meeting  place  loaned  to  them  from  time 
to  time  in  the  office  of  some  firm  of  lawyers  or  some  trust 
company;  the  name  of  the  company  is  usually  posted  some- 
where so  that  no  one  may  fail  to  find  the  company  or  its 
representative  if  he  so  desires.  At  the  entrance  to  the  office 
of  the  Corporation  Trust  Company  in  Jersey  City,  there  is  a 
directory  of  several  hundred  corporations  all  of  which  have 
their  "principal  business  office"  with  the  Corporation  Trust 
Company. 


THE   CORPORATION  -I 

It  would  not  be  advisable  to  enter  here  into  other  details 
as  to  the  provisions  of  the  charter  and  the  methods  of  incor- 
porating. The  reader  who  desires  more  detailed  information 
can  easily  obtain  it  by  consulting  the  statutes  of  his  own  state 
or  by  referring  his  inquiries  to  a  capable  lawyer. 

Operation  in  Other  Jurisdictions 

After  a  corporation  has  obtained  a  charter,  it  must  still 
face  the  question  of  ascertaining  its  rights  and  powers  outside 
of  its  home  state  if  it  desires  to  do  an  interstate  or  an  inter- 
national business.  Strictly  speaking,  a  charter  does  not  in 
itself  create  an  existence  that  can  be  recognized  outside  the 
state  or  nation  which  gives  the  charter.  The  "domicile"  of 
the  corporation,  as  the  lawyers  explain  it,  must  be  within  its 
home  jurisdiction.  In  the  famous  case  of  the  Bank  of  Augusta 
V.  Earle,  decided  in  1839,  the  United  States  Supreme  Court 
said,  speaking  of  incorporation:  "It  exists  only  in  the  con- 
templation of  the  law  and  by  virtue  of  the  law,  and  where 
that  law  ceases  to  operate  and  is  no  longer  obligatory,  the 
company  can  have  no  existence.'*  If  this  theory  were  always 
literally  and  fully  applied,  it  would  be  necessary  to  create  a 
new  corporation  for  every  state  in  which  an  enterprise  is 
being  conducted.  To  avoid  so  unworkable  a  conclusion,  Chief 
Justice  Story  brought  into  play  the  doctrine  of  interstate  and 
international  comity.  "The  laws  of  one  state,"  he  said,  "have 
no  binding  force,  it  is  true,  in  any  other  state  but  they  should 
be  recognized  and  so  far  as  possible  applied  as  a  matter  of 
courtesy."  The  comments  of  the  English  barrister,  E.  Hilton 
Young,  on  the  doctrines  of  corporate  entity  and  of  interstate 
comity  in  American  jurisprudence,  are  amusing  and  well 
founded.  "No  sooner  is  it  admitted,"  he  says,  "that  juristic 
persons  have  no  existence  except  in  the  contemplation  of  the 
law  which  created  them,  than  a  fiction  is  invented  to  enable 
them  to  claim  a  universal  existence.    A  fictitious  disability  is 


32  FINANCE   AND   BUSINESS    ORGANIZATION  m 

overcome  by  a  fictitious  recognition,  and  thus  one  fiction 
cancels  out  the  other/' 

Operation  in  Foreign  Countries 

The  tendency  of  modern  thought  and  practice  Is  toward 
giving  recognition  in  all  civilized  countries  to  commercial 
associations  formed  under  the  laws  of  other  countries.  In 
England  the  "Companies  Consolidation  Act''  of  1908  requires 
certain  formalities  of  foreign  companies  which  carry  on  busi- 
ness in  the  United  Kingdom ;  by  complying  with  these  formali- 
ties, any  such  company  may  open  a  branch  office  and  operate 
on  equal  terms  with  English  companies.  Conventions  have 
been  made  by  England  with  France,  Belgium,  Italy,  Germany, 
Spain,  Greece,  Tunis,  Austria,  and  Russia  for  reciprocal  ad- 
mission of  commercial  associations  to  civil  rights.  Since  early 
in  the  sixteenth  century,  It  has  been  agreed  that  "a  foreign 
corporation  can  appear  in  Its  corporate  character  before  the 
English  courts  and  be  regarded  as  a  person  by  the  laws  of 
England." 

In  nearly  all  the  Latin  countries,  not  only  of  Europe  but  ' 
also  of  South  America,  it  Is  easy  for  a  foreign  corporation  to 
obtain  rights  equivalent  to  those  of  a  domestic  corporation  by 
the  same  simple  process  of  registration.  Among  European 
countries,  Russia  and  Austria  are  reported  to  be  most  hostile 
toward  foreign  corporations,  while  Italy  and  England  assume 
an  especially  liberal  attitude. 

A  fair  illustration  of  international  practice  is  the  current 
law  of  Argentina  with  regard  to  foreign  corporations,  which 
is  as  follows: 

Article  I. — Corporations  organized  under  the  laws  of 
foreign  countries  may  do  business  in  the  nation  without 
previously  acquiring  the  authority  of  the  government 
providing  they  give  proof  before  competent  magistrates 
of  having  been  constituted  in  accordance  with  the  law  of 


THE   CORPORATION  33 

their  respective  countries  and  register  the  statutes  and 
other  documents  appertaining  thereto  with  the  PubHc 
Registrar  of  trade. 

Article  11. — The  provisions  of  the  preceding  article 
shall  from  the  promulgation  of  this  act  be  in  force  for 
the  corporations  whose  country  of  origin  admits  reci- 
procity. 

One  question  that  arises  in  connection  with  all  foreign  cor- 
porations is:  When  may  it  be  said  to  be  ''doing  business" 
within  a  given  jurisdiction?  The  customary  rule  is  to  the 
effect  that  isolated  transactions  may  be  carried  on  by  any  cor- 
poration without  its  having  been  previously  registered  and 
licensed,  just  as  by  any  natural  person.  But  in  case  a  foreign 
corporation  is  conducting  a  regular  business  and  especially  if 
it  is  maintaining  a  branch  office,  then  it  must  be  registered  in 
order  to  make  its  contracts  enforcible.  There  is,  of  course, 
no  fixity  about  this  rule,  and  it  is  often  a  delicate  question  to 
tell  whether  a  corporation  is  actually  doing  business  within  a 
given  jurisdiction  or  not. 

Internal  Regulations  and  By-Laws 

A  corporation,  having  obtained  its  charter  or  fundamental 
constitution  from  the  state,  is  expected  to  draw  up  and  enforce 
its  own  internal  regulations.  It  usually  at  once  adopts  written 
by-laws  as  its  internal  code.  Thousands  upon  thousands  of 
corporations,  having  adopted  excellent  by-laws,  thereafter  dis- 
regard them  as  completely  as  if  they  had  never  existed.  The 
larger  concerns,  however,  in  connection  with  which  more 
formality  is  necessary,  and  the  smaller  concerns  in  which  there 
is  current  or  probable  friction  among  the  members  of  the 
board,  quickly  discover  that  the  by-laws  are  intended  to  be 
observed  carefully  and  that  by  so  doing  much  useless  trouble 
may  be  averted. 

The  statutes  of  the  State  of  California  give  a  statement  of 


34 


FINANCE  AND   BUSINESS   ORGANIZATION 


the  subjects  which  should  be  covered  in  the  by-laws  of  a  cor- 
poration, as  follows : 

1.  The  time,  place,  and  manner  of  calling  and  conducting 

meetings. 

2.  The  number  of  stockholders  constituting  a  quorum. 

3.  Mode  of  voting  by  proxy. 

4.  The  qualifications  and  duties  of  directors,  and  also  the 

time  and  method  of  their  annual  election. 

5.  The  qualifications  and  duties  of  officers. 

6.  The  manner  of  election  and  tenure  of  office  of  all 

officers  other  than  the  directors. 

7.  Suitable  penalties  for  violation  of  the  by-laws.  fl 

Among  the  other  subjects  which  are  not  essential,  but  are 
frequently  treated,  are: 

8.  Electing  directors  to  fill  vacancies  up  to  the  next  sue-  1 

ceeding  meeting  of  the  stockholders.  ^ 

9.  Order  of  business  at  directors'  meetings. 

10.  Compensation  of  directors  and  officers. 

11.  Organization  of  standing  committees  of  the  board  of 

directors. 

Rights  and  Duties  of  Shareholders  1 

The  men  who  took  part  in  the  early  English  joint-stock 
enterprises — such  as  trading  expeditions  to  the  Indies  or 
Americas — were  appropriately  known  as  "adventurers."  The 
title  would  not  be  inappropriate  in  many  cases  if  it  were  ap- 
plied to  present-day  shareholders  in  corporations.|  The  average 
shareholder  in  a  large  corporation  has  the  privilege  of  paying 
out  money  in  return  for  which  he  receives  his  holdings  of 
stock,  and  has  the  right  to  his  proportionate  share  of  whatever 
profits  are  distributed.  He  has  also  the  right — which  the 
small  shareholder  seldom  exercises — of__v^4ifig.  for  directors 
who  are  supposed  to  represent  him.|    That  duty  having  one 


THE   CORPORATION 


35 


been  performed,  he  ceases  to  be  a  factor  of  much  importance 
in  the  management  of  the  company;  in  fact,  as  a  shareholder, 
he  probably  does  nothing  except  hopefully  wait  for  and  grate- 
fully receive  whatever  dividends  the  board  of  directors  sees 
fit  to  allot  to  him. 

The  American  Practice 

In  American  practice  the  average  shareholder,  even  of 
smaller  corporations,  unless  he  happens  to  be  also  a  director 
or  other  officer,  is  not  only  helpless,  but  uninformed.  He  may 
be  furnished,  if  it  so  pleases  the  directors,  with  a  fairly  com- 
plete annual  report;  the  more  enlightened  corporations  even 
send  out  monthly  or  quarterly  statements  of  earnings.  He . 
does  not,  however,  meet  his  directors  and  officer^  face  to  face 
unless  as  a  purely  personal  or  exceptional  event.  He  does 
not  ask  questions;  he  has  no  representative  to  dig  up  informa- 
tion for  him ;  he  is  completely  in  the  dark  as  to  the  plans 
formulated  by  the  directors  and  even  as  to  the  real  results 
and  prospects  of  his  corporation.  There  are,  of  course,  some 
exceptional  cases.  A  few  stockholders  occasionally  drift  into 
the  annual  meetings  of  large  corporations,  but  these  meetings 
are  of  so  formal  a  character  that  the  stockholders  who  attend 
are  not  likely  to  be  men  of  much  weight  and  influence.  Partly 
because  of  these  conditions,  many  able  business  men  decline  to 
invest  in  any  corporation  in  which  they  cannot  protect  their 
interests  by  a  controlling  voice  or  at  least  a  seat  in  the  direc- 
torate. 

In  other  countries,  the  tendency  of  the  management  to 
ignore  the  stockholders  has  not  yet  gone  so  far.  Corporations 
in  these  countries  are  not  of  such  enormous  size  as  those  in 
America.  The  custom  of  meeting  the  directors  and  officers  at 
least  once  a  year  and  of  persistently  seeking  information  as 
to  the  internal  affairs  of  the  company  has  not  fallen  so  com- 
pletely into  disuse. 


36  FINANCE   AND   BUSINESS   ORGANIZATION 

The  English  Practice 

The  English  statutes  provide  for  the  auditing-  of  each 
company's  accounts  by  an  independent  accountant  elected  by 
the  shareholders.  The  auditor  is  responsible  to  the  share- 
holders and  not  to  the  directors,  and  he  is  legally  liable  to 
reimburse  the  company  for  any  loss  which  he  might  have 
prevented.  The  courts  have  said  that  it  is  the  duty  of  an 
auditor  not  to  confine  himself  to  verifying  the  arithmetical 
accuracy  of  the  balance  sheet,  but  to  inquire  into  its  substantial 
accuracy.  The  report  of  the  auditor  must  be  sent  to  the 
shareholders.  The  courts  have  further  said  that  an  auditor 
does  not  discharge  his  duty  by  simply  putting  the  shareholders 
in  the  way  of  obtaining  information;  he  must  state  his  con- 
clusions in  unmistakable  terms. 

The  absence  of  any  corresponding  machinery  In  the  United 
States  places  the  shareholder  in  a  peculiarly  helpless  situation, 
especially  when  he  suspects  Impropriety  on  the  part  of  his 
directors.  On  July  2,  19 14,  W.  Bourke  Cockran,  an  eminent 
New  York  attorney,  representing  a  stockholder  of  the  Inter- 
national Steam  Pump  Company,  appeared  before  the  Supreme 
Court  of  the  State  of  New  York  in  an  effort  to  compel  the 
directors  of  the  company  to  furnish  more  complete  data  than 
his  client  had  previously  been  able  to  secure.  ^'Doesn't  the 
existing  law  on  corporations  give  you  sufificlent  power  to  go 
in  and  inspect  the  books?"  asked  Justice  Weeks.  ''Why,  your 
Honor,"  replied  Mr.  Cockran,  "they  would  only  laugh  at  any 
one  who  really  tried  to  get  at  the  books.  It  would  take  until 
doomsday." 

Under  recent  decisions  the  New  York  courts  have  made 
it  possible  for  shareholders  to  Inspect  the  stock  ledger  and 
transfer  books  of  their  corporations  for  the  purpose  of  pro- 
curing a  list  of  the  stockholders.  This  right  has,  beyond 
question,  been  abused  by  various  individuals  who  have  made 
topics  of  lists  of  shareholders  for  the  mere  purpose  of  using 


THE   CORPORATION 


37 


them  as  mailing  lists  for  advertising  purposes.  These  lists  of 
shareholders  of  important  corporations  have  even  been  ad- 
vertised for  sale.  Nevertheless,  in  spite  of  this  abuse,  the 
right  must  be  maintained  and  enforced;  otherwise  a  share- 
holder of  a  large  corporation,  even  though  he  might  have 
important  information  that  would  affect  the  votes  of  his 
fellow  shareholders,  would  have  no  economical  and  effective 
way  of  communicating  with  them. 

On  the  basis  of  what  has  just  been  said  as  to  the  rights 
of  shareholders,  it  is  evident  that  large  discretionary  powers 
must  be  left  to  the  directors.  No  matter  what  improvements 
might  be  made  in  the  relations  of  the  shareholders  to  their 
corporation,  they  could  not  themselves  undertake  the  direct 
management  of  its  affairs.  In  very  small  or  close  corporations 
it  is  possible  that  the  individual  shareholder  may  have  some 
personal  influence  which  could  be  made  of  value  to  the  cor- 
poration, but  in  large  corporations  the  individual  can  accom- 
plish little  except  through  his  vote  or  through  membership 
on  the  board  of  directors.  The  Pennsylvania  Railroad  Com- 
pany has  over  93,000  shareholders,  of  whom  45,000,  or  nearly 
one-half,  are  women;  the  women  shareholders  own  over  28%. 
of  the  outstanding  stock.  The  American  Telephone  and 
Telegraph  Company  has  62,000  shareholders  and  the  United 
States  Steel  Corporation  has  110,000. 

Rights  and  Duties  of  Directors 

The  board  of  directors  has  the  final  legislative  and  judicial 
authority  within  a  corporation.  The  board  elects  officers, 
determines  policies,  authorizes  contracts,  passes  on  methods  ofl 
financing,  declares  or  withholds  dividends,  and  in  general/ 
manages  all  the  affairs  of  the  corporation.  This  describes 
their  legal  status  and  responsibilities. 

In  practice,  however,  boards  of  directors  are  likely  to 
become  mere  appendages  or  echoes  of  some  one  or  two  in- 


38  FINANCE  AND   BUSINESS   ORGANIZATION  j 

dividuals  who  actually  direct  the  corporation.  The  real,  final 
authority  is  frequently  lodged  in  the  president,  if  he  is  an 
active  man  and  performs  all  the  duties  of  his  office,  and  the 
board  of  directors  simply  ratifies  his  decisions.  This  is  fre- 
quently the  case  even  though  the  directorates  may  be  made 
up  of  able  and  forceful  men.  Under  the  American  system 
they  have  no  direct  interest,  except  as  shareholders,  in  the 
profits  of  the  corporation,  and  cannot  afford  to  devote  a  great 
deal  of  time  and  thought  to  its  activities.  They  have  con- 
fidence, presumably,  in  the  president  or  in  the  chief  officer 
or  officers,  whoever  they  may  be,  and  they  prefer  for  their 
own  convenience  and  comfort  to  leave  the  whole  corporatioi 
in  the  care  of  its  actual  head.  The  thing  that  frequently  hap- 
pens, therefore,  is  that  the  shareholders  elect  directors;  the 
directors  elect  a  president  or  other  chief  officer;  and  this  man 
designates  the  other  officers,  fixes  the  policy  of  the  concern, 
and  carries  on  all  its  affairs  subject  only  to  the  formal  ratifica- 
tion of  his  board.  So  long  as  the  president  and  other  officials 
are  well  chosen,  the  system  works  well.  Its  weakness  lies  in- 
the  fact  that  the  directors  themselves  are  poorly  informed  and 
are  left  in  a  helpless  or  ignorant  condition  as  compared  with 
the  officers;  hence  they  are  quite  unable  to  protect  themselves 
or  the  corporation  against  practices  on  the  part  of  the  officers 
that  are  perhaps  detrimental.  In  place  of  a  representative  J 
democracy,  which  is  the  ideal  form  of  government  for  a  cor-" 
poration,  they  substitute  a  small  tyranny. 

This  common  state  of  affairs  is  due,  in  the  United  States, 
partly  to  the  custom  of  choosing  directors  of  important  cor- 
porations from  a  very  small  circle  of  well-known  business 
men.  The  result  is  that  one  man  may  serve  on  lo,  20,  50,  or 
even  75  different  boards.  Even  though  some  of  these  boards 
may  be  those  of  subsidiary  corporations  which  transact  noth- 
ing but  the  most  formal  business,  nevertheless  the  men  who 
are  members  of  so  many  boards  cannot  be  thoroughly  in- 


THE   CORPORATION  39 

formed  as  to  any  of  them.  Within  the  last  two  or  three  years, 
there  has  been  a  significant  tendency  to  reduce  the  number  of 
directorates  of  which  one  man  is  a  member,  but  the  number 
is  still  too  large.  William  H.  Newman,  for  instance,  Chair- 
man of  the  Board  of  the  New  York  Central  Railroad  Com- 
pany, who  was  at  one  time  a  director  in  112  separate  corpora- 
tions, is  now  a  director  in  73  companies.  H.  L.  Doherty,  who 
is  largely  interested  in  public  utility  properties,  is  a  director  in 
66  corporations.  W.  K.  Vanderbilt,  Jr.,  is  a  director  in  65 
corporations.  E.  T.  Stotesbury  is  a  director  in  58  corpora- 
tions. In  England  there  was  at  one  time  a  custom  of  filling 
directorates  with  gentlemen  of  title,  most  of  whom  were  in- 
credibly ignorant  of  all  business  transactions.  More  recently, 
according  to  Hartley  Withers,  it  is  becoming  more  the  fashion 
to  put  in  men  who  are  supposed  to  know  something  about 
the  business,  "but  the  real  requirement,  that  of  genuine  busi- 
ness capacity,  is  still  to  a  large  extent  left  out  and  probably 
must  be  as  long  as  directors'  fees  are  on  their  present  ab- 
surdly small  scale." 

Corporate  Officers  and  Directors 

At  the  other  extreme  is  the  small  corporation  which  makes  v 
all  its  officers  directors  and  allows  its  directors  to  make  them- 
selves officers.  It  is,  of  course,  quite  proper  and  customary 
that  some  of  the  leading  officials  should  be  included  in  the 
directorate,  but  a  directorate  that  is  made  up  wholly  of  officers 
is  obviously  a  body  in  which  there  is  great  danger  of  "log 
rolling."  An  officer  who  is  also  a  director  cannot  easily  afford 
to  oppose  fellow  officers  and  directors  who  have  complete 
power  over  him.  If  there  are  no  outside  directors  who  are 
not  involved  in  the  internal  affairs  of  the  corporation  to  whom 
he  may  appeal,  an  honest,  zealous  officer  is  peculiarly  in  a 
position  of  disadvantage.  The  custom  of  having  all  or  nearly- 
all  of  the  directors  chosen  from  the  officers  of  the  corporation 


v^X 


40  FINANCE   AND   BUSINESS   ORGANIZATION 

may  work  well  for  temporary  periods  just  as  any  other  un- 
sound arrangement  may  work  for  a  time.  It  is,  however, 
fundamentally  incorrect  and  has  many  times  proved  a  fruitful 
source  of  friction  and  inefficiency. 

The  "Clayton  Bill" 

The  so-called  "Clayton  Bill"  of  October  15,  1914,  now 
makes  unlawful  in  the  United  States  the  practice  of  serving 
on  the  directorates  of  two  or  more  banks,  either  of  which 
has  deposits,  surplus,  and  undivided  profits  aggregating  more 
than  $5;000,ooo.  The  Act  further  provides  that  no  citizen 
shall  be  a  director  in  two  or  more  competitive  corporations 
engaged  in  whole  or  in  part  in  commerce,  any  one  of  which 
has  capital,  surplus,  and  undivided  profits  aggregating  more 
than  $1,000,000.  The  purpose  of  this  measure  was  to  inter- 
pose obstacles  in  the  way  of  improper  restraint  of  trade.  Its 
effectiveness  in  accomplishing  this  purpose  is  open  to  question. 
As  a  method  of  discouraging  business  men  from  attempting 
to  serve  on  too  many  directorates  and  of  opening  up  more 
opportunities  to  other  men  of  perhaps  equal  ability  but  of 
narrower  reputation,  however,  it  will  be  beneficial  so  far  as 
it  goes. 

"Ornamental  Directors" 

The  report  of  the  Interstate  Commerce  Commission  in 
1914  on  the  financial  history  and  status  of  the  New  York, 
New  Haven  and  Hartford  Railroad,  strongly  condemns  in- 
activity and  ignorance  on  the  part  of  the  directors.  "There 
are  too  many  ornamental  directors,"  to  quote  the  plain 
language  of  the  Commission,  "who  have  such  childlike  faith 
in  the  man  at  the  head,  that  they  are  ready  to  endorse  or 

approve  anything  he  may  do The  minutes  of  the  New 

Haven^s  meetings  reveal  that  the  Board  confined  itself  almost 
wholly  to  ratifying  and  authorizing  action;  there  was  little 


THE  CORPORATION  4I 

real  information  or  discussion.  None  of  the  directors  would 
have  been  so  careless  in  the  handling  of  his  own  money  as 
the  evidence  demonstrated  they  were  in  dealing  with  the 
money  of  other  people." 

On  the  other  hand,  there  is  sometimes  a  mistaken  idea 
that  the  hoard  of  directors-  ought  to  manage  all  the  details 
of  a  business.  Its  real  function  is  selecting  the  right  officials, - 
outlining  policies,  and  passing  well-informed  judgment  from 
time  to  time  as  to  the  efficiency  and  honesty  of  the  manage- 
ment. One  of  the  most  successful  publishers  in  the  United 
States,  Colonel  Henry  Watterson  of  Louisville,  recently  gave 
his  opinion  on  the  witness  stand  of  directorates  which  run 
too  much  to  details.  Referring  to  the  management  of  the 
New  York  World  after  the  death  of  the  organizer  and  former 
proprietor,.  Joseph  Pulitzer,  Colonel  Watterson  said :  "I  un- 
derstand that  the  paper  is  edited  by  a  Board  of  Directors. 
You  might  as  well  try  to  run  a  locomotive  by  a  Board  of 
Directors.  The  moment  the  wisdom  of  one  man  or  two  men 
is  superseded  by  the  folly  of  one  man  or  two  men,  the  efforts 
of  a  lifetime  may  then  and  there  be  wrecked.  It  has  been 
done  repeatedly." 

Compensation  of  Directors 

It  has  been  suggested  that  one  reason  for  the  inefficiency 
and  the  light  ethical  standards  of  the  directorates  of  some 
important  corporations,  is  to  be  found  not  only  in  wrong 
practice  in  selecting  these  men,  but  also  in  wrong  practice  in 
compensating  them.  In  many  foreign  countries,  notably  in 
continental  Europe,  it  is  the  custom  to  distribute  among  the 
directors  at  the  end  of  each  year,  a  fixed  percentage  of  the 
net  profits;  thus  each  director,  even  though  he  may  not  be  a 
heavy  shareholder,  has  a  direct  and  personal  interest  in  build- 
ing up  the  profits.  He  is  less  likely  to  wink  at  incompetence 
or  to  avoid  criticism  that  would  be  for  the  good  of  the  cor- 


42  FINANCE  AND   BUSINESS   ORGANIZATION 

poration,  if  he  realizes  that  he  must  himself  pay  a  portion 
of  the  penalty  in  the  form  of  reduced  compensation.  Paul 
Warburg,  formerly  of  the  firm  of  Kuhn,  Loeb  and  Company, 
has  expressed  his  belief  that  in  this  country  we  should  follow 
the  European  plan  of  paying  directors  in  proportion  to  the 
dividends  they  can  earn.  One  important  gain  in  this  plan 
is  that  it  becomes  easier  to  secure  as  directors  men  who  may 
themselves  have  only  a  small  shareholding  interest  in  the 
corporation;  the  range  of  choice  is  widened.  As  matters 
stand  now,  a  man  wishes  to  be  a  director  of  an  important 
corporation  for  either  one  of  two  reasons:  because  he  has  a 
large  share-interest  that  he  feels  he  should  protect,  or  because 
it  adds  to  his  prestige.  This  second  motive  has  a  strong 
influence  in  making  up  the  directorates  of  banking  institutions. 
"Membership  on  the  boards  of  good  banks,"  someone  has 
said,  "is  largely  a  social  function."  This  is  not  the  way  to 
get  efficient,  hard-working  directors.  Under  our  system  it 
is  common  practice  to  pay  nominal  fees  for  attendance  at 
board  meetings,  but  they  seldom  amount  to  more  than  $20  a 
meeting,  and,  therefore,  these  fees  are  not  a  factor  of  any  real 
weight. 

This  question  of  compensation  as  well  as  some  other  ques- 
tions thaf  are  touched  upon  in  this  section,  will  come  up  for 
fuller  discussion  when  we  consider  the  subject  of  exploitation 
of  corporations.     (See  Chapters  XXIII,  XXIV.) 

Legal  Status  of  Directors 

As  to  the  legal  status  and  responsibilities  of  a  director,  it 
seems  to  be  well  settled  that  a  director  is  a  quasi-trustee  on 
behalf  of  the  body  of  shareholders.  He  is  certainly  not  en- 
titled, either  legally  or  morally,  to  use  his  position  primarily 
for  his  personal  profit  at  the  expense  of  the  other  shareholders. 
While  there  is  no  question  that  this  is  frequently  done,  and 
as  we  shall  see  later  on  is  often  defended,  it  is  permitted  in 


THE  CORPORATION  43 

many  companies  to  continue  only  because  the  shareholders 
cannot  offer  legal  proof  of  their  suspicions. 

A  director  ordinarily  is  not  liable  to  the  stockholders  for- 
acts  of  his  co-directors  unless  he  participates  in  the  action  or 
acquiesces  by  not  making  a  vigorous  protest.  Just  what  is 
meant  by  "vigorous  protest"  is  difficult  to  say.  Where  the 
wrong  is  serious,  the  directors  ought  to  apply  to  the  courts. 
In  New  York  State  there  is  a  provision  to  the  effect  that 
directors  must  file  their  protest,  in  writing,  or  cause  it  to  be 
entered  in  writing  on  the  minutes. 

Contracts  with  Directors 

A  question  that  frequently  arises,  relates  to  contracts  be- 
tween a  corporation  and  a  director,  or  between  a  corporation 
and  another  enterprise  in  which  a  director  is  interested.  There 
are  several  views  in  the  various  jurisdictions  as  to  the  validity 
of  such  contracts.  In  New  York  the  law  is  somewhat  un- 
settled, but  several  decisions  have  been  made  to  the  effect 
that  they  are  voidable  but  not  void,  and  that  they  are  there- 
fore binding  on  the  corporation  at  its  own  option.  The 
United  States  Supreme  Court  has  held  that  such  contracts 
may  be  voided  if  lack  of  good  faith  is  proven,  but  that  they 
are  presumptively  valid.  The  United  States  Steel  Corporation 
has  an  interesting  proviso  in  its  by-laws  covering  this  point, 
which  reads  as  follows: 

Inasmuch  as  the  directors  of  this  Company  are  men 
of  large  and  diversified  business  interests,  and  are  likely 
to  be  connected  with  other  corporations  with  which  from 
time  to  time  this  Company  must  have  business  dealings, 
no  contract  or  other  transaction  between  this  Company 
and  any  other  corporation  shall  be  affected  by  the  fact 
that  directors  of  this  Company  are  interested  in  or  are 
directors  or  officers  of  such  other  corporation,  if  at  the 
meeting  of  the  Board  or  at  the  Committee  of  this  Con> 


44  FINANCE  AND   BUSINESS   ORGANIZATION 

pany  making,  authorizing  or  confirming. such  contract  or 
transaction,  there  shall  be  present  a  quorum  of  directors 
not  so  interested;  and  any  director  individually  may  be 
a  party  to  or  may  be  interested  in  any  contract  or  trans- 
action of  this  Company  provided  that  such  contract  or 
transaction  shall  be  approved  or  be  ratified  by  the  affirma- 
tive vote  of  at  least  lo  directors  not  so  interested- 


CHAPTER    IV 

THE  CORPORATE  FORM— ADVANTAGES  AND 
DISADVANTAGES 


Corporations  in  Modern  Business 

The  great  commercial  agencies  of  the  United  States  list 
about  1,700,000  individuals,  firms,  and  corporations  as  being 
in  business.  About  350,000  corporations  in  the  United  States 
made  returns  under  the  Corporation  Tax  Law  of  the  United 
States  for  the  calendar  year  19 12.  This  would  seem  to  in- 
dicate that  about  one-fifth  of  all  business  enterprises  are  or- 
ganized in  the  corporate  form.  However,  these  figures  do 
not  in  themselves  give  anything  like  an  adequate  idea  of  the 
relative  importance  of  the  corporate  form.  The  80%  of  busi- 
ness enterprises  owned  by  individuals  or  by  partnerships  in- 
clude, with  comparatively  few  exceptions,  only  small  concerns. 
The  350,000  corporations  include  nearly  all  the  important  en- 
terprises of  the  country.  It  is  interesting  to  note  the  distribu- 
tion of  these  350,000  corporations  on  the  basis  of  their  capi- 
talization, which  is  as  follows: 

296,670  corporations  with  capital  of  less  than  $1,000,000 


4,688 

1,399 
677 
292 
861 
652 
62 
65 


$1,000,000  to    $2,000,000 
2,000,000   "       3,000,000 


3,000,000 

4,000,000 

5,000,000 

10,000,000 

50,000,000 


4,000,000 

5,000,000 

10,000,000 

50,000,000 

100,000,000 


100,000,000   and  over 


In  other  countries  also,  large  enterprises  are  almost  always 
organized  under  the  form  corresponding  to  the  corporation.  In 

45 


46  FINANCE  AND   BUSINESS   ORGANIZATION 

the  three  years  1911-1913,  nearly  1,000  joint-stock  companies 
were  authorized  to  operate  in  Russia ;  the  average  capital  was 
about  $750,000,  showing  that  they  were  nearly  all  large  en- 
terprises. In  Japan,  out  of  1,445  commercial  banks,  only  54 
are  owned  by  individuals  and  the  rest  by  joint-stock  companies. 

The  Number  of  Small  Corporations 

Yet,  the  corporation  is  by  no  means  confined  in  its  useful- 
ness to  concerns  doing  an  enormous  business.  On  the  con- 
trary, it  is  becoming  every  year  more  and  more  frequent  to 
organize  even  small  enterprises  in  this  form.  The  ''one-man 
corporation"  or  "the  close  corporation"  is  no  longer  an  isolated 
phenomenon.  Thousands  of  men  who  prefer  to  have  them- 
selves and  their  estates  relieved  from  possible  liabilities  due  to 
misfortunes  of  business,  or  who  wish  to  organize  in  such  a 
way  that  it  will  be  easy  to  sell  interests  or  gradually  to  transfer 
the  control,  have  decided  to  adopt  the  corporate  form.  The 
expense  of  so  doing  is  slight,  and  they  feel  that  it  is  well 
worth  while. 

It  is  becoming  more  and  more  common  also  to  incorporate 
the  estates  of  deceased  persons  and  to  distribute  shares  in  the 
corporation  among  the  heirs  of  the  estate  so  that  a  proper 
division  of  interest  may  be  secured  without  a  physical  division 
or  forced  sale  of  the  property.  Small  corporations  for  tem- 
porary purposes,  also,  are  not  uncommon.  An  individual  may 
get  up  a  corporation  to  publish  a  book  or  to  carry  through  a 
piece  of  speculating  in  real  estate. 

Indeed,  the  question  is  often  raised  whether  this  tendency 
is  not  being  overdone ;  whether  many  enterprises  that  would  be 
better  off  as  temporary  syndicates  or  as  special  partnerships, 
are  not  unthinkingly  being  made  over  into  corporations.  As 
regards  many  individual  cases,  the  question  is  no  doubt  well 
justified.  On  the  whole,  however,  there  can  be  little  question 
but  that  the  corporation  has  proved  itself  useful,  sound,  and 


THE  CORPORATE  FORM  47 

economical,  not  only   for  nation-wide  and  world-wide  con- 
cerns, but  for  small  and  local  enterprises  as  well. 

The  Army  of  Stockholders 

Another  point  to  consider  here  is  the  great  number  of 
persons  interested  in  corporations  as  holders  of  their  stocks 
and  bonds.  Recently,  195  companies  have  reported  to  the 
Wall  Street  Journal  a  total  of  779,054  stockholders.  This 
takes  no  account  of  bondholders.  There  is,  of  course,  a  vast 
amount  of  duplication  due  to  the  fact  that  the  lists  of  these 
195  companies  are  not  checked  against  each  other,  and  one 
man  may  be  a  stockholder  in  a  great  many  different  com- 
panies. Even  making  this  deduction,  it  is  clear  that  American 
corporations  have  a  great  number  of  stockholders.  On  a 
smaller  scale,  the  same  thing  is  true  in  other  countries.  It 
constitutes  one  sound  reason  for  saying  that  the  corporate 
form  of  organizing  enterprises  is  becoming  one  of  the  far- 
reaching  factors  in  modern  business  life. 

Tj'^pes  of  Business  Corporations 

Some  reference  has  been  made  in  Chapter  III  to  the  an- 
cient religious  and  charitable  corporations  from  which  the 
idea  of  a  distinct  existence  for  the  corporation,  apart  from 
the  people  who  organize  and  manage  it,  was  derived  and  ap- 
plied to  business  corporations.  In  modern  times  this  class 
of  religious  and  charitable  corporations  has  been  broadened 
to  include  all  corporations  not  organized  for  profit.  They  are 
often  spoken  of  as  "non-stock"  corporations.  This  term  now 
includes  municipal  and  other  chartered  governments  and 
societies,  as  well  as  religious  and  charitable  corporations.  For 
the  most  part  these  non-stock  corporations  are  not  concerned 
directly  with  business  enterprises,  and  we  need  give  them  no 
further  consideration.  There  are  a  few  exceptional  cases  of 
corporations  chartered  in  this  form  for  business  purposes, 


48  FINANCE  AND   BUSINESS   ORGANIZATION 

such  as  stock  and  produce  exchanges  and  business  associations 
of  various  types. 

Close  and  Open  Corporations 

In  the  ordinary  business  corporation,  an  important  prac- 
tical distinction  is  to  be  made  between  "close"  and  "open" 
corporations  (in  England  more  frequently  called  "private" 
and  "public"  corporations).  A  "close"  corporation  is  one  the 
stock  of  which  is  held  by  only  a  few  persons  who  make  very 
few  purchases  or  sales  so  that  there  is  no  public  market  for 
this  stock.  An  "open"  corporation  is  one  the  stock  of  which 
is  constantly  being  bought  and  sold  so  that  the  ownership 
varies  from  time  to  time.  There  is  obviously  no  clear-cut  line 
of  distinction.  Many  corporations  enjoy  only  a  small  and 
local  market  for  their  shares,  but  nevertheless  are  in  part 
"open"  in  the  sense  that  there  would  be  no  difficulty  for  an 
outsider  to  purchase  a  few  shares  at  any  time  he  chose.  On 
the  other  hand,  there  are  many  large  and  highly  successful 
corporations  the  stock  of  which  is  in  the  hands  of  a  few  in- 
dividuals who  do  not  care  to  dispose  of  it.  As  will  be  pointed 
out  more  fully  a  little  later,  the  tendency  in  the  United  States 
has  been  to  concentrate  the  attention  of  the  investing  and 
speculating  public  largely  on  the  shares  of  a  few  great  corpora- 
tions, with  the  result  that  other  corporations  have  not  had  as 
full  and  free  a  market  for  their  shares  as  may  be  found  for 
corporations  of  the  same  size  and  class  in  other  countries. 

A  "close"  corporation  is  usually  a  direct  successor  to  a 
partnership;  or,  if  not,  is  a  small  concern.  As  a  business 
enterprise  expands  and  more  and  more  people  become  in- 
terested, first  the  partnership  is  changed  to  a  corporation,  and 
later  the  shares  of  the  corporation  begin  to  be  passed  from 
hand  to  hand.  Almost  insensibly  the  concern  gradually  begins 
to  emerge  from  the  ranks  of  "close"  corporations  and,  if  it 
keeps  on  expanding,  eventually  finds  its  shares  widely  dis- 


THE   CORPORATE   FORM 


49 


tributed  and  passed  from  hand  to  hand.  This  is  the  common, 
but  not  the  universal,  process.  Among  the  large  companies  in 
the  United  States  the  shares  of  which  are  reported  to  be 
closely  held,  are  the  Winchester  Repeating  Arms  Company, 
the  Mills  and  Gibb  Company,  the  Jones  and  Laughlin  Steel 
Company,  and  the  Cerro  de  Pasco  Investment  Company. 

Holding  Companies 

A  striking  development  of  recent  years  has  been  the  grow- 
ing use  and  importance  of  companies  which  hold  the  stock 
of  other  corporations.     There  was  originally  no  thought  that 
corporations  might  be  organized  for  any  other  purpose  than 
to  conduct  directly  the  business  operations  specified  in  their, 
articles  of  incorporation.    It  was  in  time  discovered,  however,- 
that  among  the  possible  powers  of  a  corporation,  it  might  hold 
securities  of  other  corporations  just  as  an  individual  might 
do.     At  the  beginning,  the  only  use  made  of  this  power  was  ) 
to  purchase  interests  that  could  be  regarded  as  useful  to  the ' 
corporation  or  as  subserving  the  main  purpose  for  which  it 
was  created.     This  remains  today  the  most  common  and  im- 
portant purpose   for  which  corporations  acquire  the  shares 
of  other  corporations. 

But  the  holding  company  device  has  proved  extremely  use-  ^ 
ful  also  for  another  purpose  on  which  public  attention  has 
been  largely  centered.  This  purpose  is  to  achieve  a  combina- 
tion of  competing  concerns  which  will  restrain  competition  and 
be  within  the  requirements  of  the  law.  This  subject  has  been 
so  fully  discussed  in  various  books  and  articles  that  it  needs 
only  a  brief  reference.  Before  the  adoption  of  the  ''holding'* 
company  device,  combinations  of  competing  concerns  had  been 
effected  in  several  different  ways.  The  first  attempt  to  achieve 
such  combinations  in  the  United  States  was  made  by  competing 
railroads  which  worked  out  various  "gentlemen's  agreements'* 
for  the  regulation  of  rates  and  competitive  methods.     These 


go  FINANCE  AND   BUSINESS   ORGANIZATION 

agreements  never  stood  the  strain  of  every-day  use  for  any 
long  period.  They  always  broke  down  because  they  were  not 
hard  and  fast  contracts;  they  were  differently  interpreted  by 
the  various  individuals  who  entered  into  them  and  had  no 
legal  sanction. 

The  Illegal  Combination 

Another  form  of  combination  that  has  proven  unsuccessful 
in  this  country — though  it  has  worked  to  some  extent  abroad 
— is  the  "pool"  or  selling  agency,  which  is  an  agreement  to 
restrict  production  and  sales,  and  which  frequently  accom- 
plishes this  purpose  by  having  all  the  sales  of  the  competing 
companies  handled  by  one  selling  organization.  This  arrange- 
ment was  found  to  be  illegal  in  this  country  and  was  given 
up  more  than  a  generation  ago. 

Its  successor  was  the  "trust,"  using  that  word  in  its  legal, 
not  its  popular,  sense.  Under  the  "trust"  form  of  combina- 
tion, controlling  shares  in  competing  corporations  were  turned 
over  to  a  group  of  trustees  who  issued  in  exchange  their 
trustees'  certificates.  The  trustees  were  able  in  this  way  to 
direct  all  the  corporations  and  to  restrain  their  competition 
with  each  other.  In  the  late  8o's  this  arrangement  also  was 
found  to  be  illegal  and  consequently  the  trusts  were  dis- 
solved. 

Shortly  afterward  began  the  use  of  the  "holding"  company 
-  to  accomplish  this  same  purpose.  One  corporation  was  formed 
which  purchased  the  controlling  shares  of  competing  corpora- 
tions and  was  thus  able  to  direct  them  in  the  same  way  that 
the  trusts  had  previously  done.  After  many  years  of  agita- 
tion and  litigation,  this  method  also  has  in  recent  years  been 
found  to  be  illegal.  Some  of  the  large  holding  companies  have 
been  dissolved  by  order  of  the  courts  and  others  have  volun- 
tarily relinquished  their  holdings  of  stocks  of  competing  com- 
panies. 


THE  CORPORATE  FORM  5 1 

Legality  of  Holding  Companies 

Out  of  the  discussion  and  the  various  legal  measures  that 
have  been  taken,  there  has  arisen  a  popular  feeling  that  all 
holding  companies  are  questionable,  and  it  has  even  been 
seriously  proposed  that  a  corporation  should  be  forbidden  to 
hold  stock  in  any  other  corporation.  Yet,  as  a  matter  of  fact, 
no  real  legal  objection  to  a  holding  company  itself  has  ever 
been  raised.  The  only  question  has  been  whether  the  holding- 
company  has  been  used  for  purpose  of  restraining  trade  and 
competition,  and  it  is  that  use  which  is  forbidden.  For  any 
purpose  that  is  not  illegal,  a  holding  company  may  be  used  as 
effectively  and  with  as  little  legal  objection  as  ever. 

Combination  of  Non-competitive  Companies 

There  are  two  other  purposes  for  which  one  corporation 
may  hold  the  stock  of  other  corporations:  one  purpose  is  to- 
bring  about  a  grouping  or  combination  of  concerns  that  are 
non-competitive ;  the  other  purpose  is  to  control  subsidiary  cor- 
porations in  such  a  way  as  to  advance  the  main  interests  of 
the  holding  company,  but  not  with  a  view  to  preventing  or 
restraining  competition.  We  find  the  best  illustration  of  the 
first  of  these  two  purposes  in  the  public  utility  field.  There 
are  about  140  large  holding  companies  which  own  controlling 
interests  in  a  number  of  electric  light  and  power,  gas,  and 
traction  corporations.  Of  approximately  $2,112,000,000  of 
securities  issued  by  electric  light  and  power  companies,  about 
82.5%  are  owned  by  these  140  holding  companies;  of  about 
$1,320,000,000  of  securities  of  artificial  gas  companies,  about 
66%  are  owned  by  the  holding  companies;  of  $4,043,000,000 
of  securities  of  traction  companies,  about  81.4%  are  owned 
by  the  holding  companies.  So  far  as  the  available  records 
show,  only  one  holding  company  in  this  class  has  ever  been 
placed  in  receivership,  and  that  was  on  account  of  financing 
large  irrigation  schemes. 


52  FINANCE   AND   BUSINESS   ORGANIZATION 

The  chief  advantages  of  applying  the  holding  company 
plan  to  public  utilities  are  : 

1.  Most  of  the  local  companies  are  in  small  cities  and 

do  not  have  the  resources  which  would  enable  them 
to  employ  high-priced  talent.  The  holding  com- 
panies, through  their  superior  resources  and  or- 
ganization, are  able  to  increase  the  efficiency  of  the 
local  companies. 

2.  While  the  securities  of  the  local  public  utilities  can 

be  sold  only  in  or  near  the  place  of  their  operations, 
the  securities  of  great  holding  companies  enjoy  a 
national  and  even  international  market  and  con- 
sequently can  be  sold  more  widely  and  on  a  much 
better  basis. 

There  appears  to  be  no  reason  to  condemn  the  holding 
company  in  this  field.  On  the  contrary,  it  has  been  continually 
an  aid  to  economy  and  efficiency.  The  London  Underground 
Electric  Railways  is  purely  a  holding  company.  There  are, 
however,  comparatively  few  examples  outside  the  United 
States  of  this  device. 

The  Use  of  Subsidiary  Corporations 

The  control  of  subsidiaries  may  be  accomplished  through 
the  creation  of  a  separate  corporation  to  handle  a  distinct  phase 
of  the  company's  business,  or  through  the  purchase  of  interests 
in  companies  previously  existing,  the  main  corporation  being 
in  this  case  the  holding  company.  The  use  of  subsidiary  cor- 
porations is  becoming  more  and  more  extensive.  A  certain 
manufacturing  corporation,  for  instance,  has  one  operating 
company,  one  selling  company,  one  purchasing  company,  one 
company  owning  a  short  railroad,  one  real  estate  company  to 
buy  land  and  erect  buildings,  and  another  company  to  operate 
these  buildings.     The  United  Cigar  Stores  Company  also  has 


THE   CORPORATE   FORM  c^ 

a  distinct  corporation  for  the  handling  of  its  real  estate  opera- 
tions. 

Advantages  of  Subsidiary  Corporations 

The  advantage  of  forming  a  distinct  corporation  rather 
than  simply  establishing  another  department  of  the  business, 
is  not  always  clear  to  the  outsider,  but  may  frequently  be  due 
to  personal  relations.  A  first-class  real  estate  man,  for  ex- 
ample, may  not  desire  to  come  to  a  corporation  as  a  paid  em- 
ployee, but  would  be  willing  to  assume  the  management  of  a 
distinct  corporation  under  conditions  that  would  enable  him 
to  secure  adequate  profit.  Again,  it  is  frequently  desired  to 
give  the  manager  of  a  plant  or  of  a  branch  ofifice  an  oppor- 
tunity to  acquire  a  personal  stock  interest  in  the  operations 
directly  under  his  control,  and  this  can  be  most  easily  done 
through  the  formation  of  a  separate  corporation.  Recently, 
a  case  was  brought  to  the  writer's  attention  of  a  furniture 
company  which  has  gradually  extended  its  business  until  it 
now  handles  various  lines  not  strictly  connected  with  the  furni- 
ture business,  including  papers  for  wrapping  and  packing 
furniture.  This  company  found  that  difficulty  was  being  ex- 
perienced by  their  sales  force  in  calling  upon  people  interested 
in  the  paper  business  because  of  the  impression  that  the  sales- 
man had  only  furniture  for  sale.  The  dif^culty  was  easily 
overcome  by  forming  a  separate  company  to  handle  the  sale 
of  paper,  with  a  separate  name,  stationery,  and  sales  man- 
ager, but  otherwise  conducted  as  a  part  of  the  parent  concern. 

It  may  be  thought  strange  that  a  corporation  holding  a 
charter  and  grant  of  powers  from  the  state,  could  be  organized 
so  lightly  and  for  so  minor  a  purpose,  yet  the  illustration  is 
not  unrepresentative.  It  has  become  so  easy  and  common  a- 
thing  to  organize  a  corporation  for  some  specific  purpose,  that 
it  is  frequently  done  with  very  little  thought  and  often  when 
little  or  nothing  is  gained.     Possibly  this  tendency  is  going  a 


54 


FINANCE   AND   BUSINESS   ORGANIZATION 


little  too  far,  and  might  properly  be  curbed  by  closer  super- 
vision on  the  part  of  the  state  and  by  somewhat  higher  or- 
ganization and  franchise  taxes.  On  the  other  hand,  we  should 
not  overlook  the  usefulness  of  the  arrangement  in  many  in- 
stances, and  should  not  be  misled  by  a  cry  against  holding  com- 
panies into  condemning  or  preventing  practices  that  on  the 
whole  make  for  business  efficiency. 

Advantages  of  Corporate  Form 

The  underlying  advantages  of  the  corporate  form  for 
most  business  concerns,  have  already  been  indicated  in  point- 
ing out  the  disadvantages  of  the  individual  proprietorship  and 
partnership.    They  may  be  listed  as  follows: 

1.  The  corporate  form  makes  it  possible  to  distribute 

ownership  among  any  number  of  persons  and 
thereby  to  raise  very  large  amounts  of  capital. 

2.  The  relationship  between  the  owner  of  a  corporate 

security  and  the  business  itself  being  purely  imper- 
sonal, the  securities  which  represent  ownership  may 
be  freely  transferred. 

These  two  points  make  a  corporation  attractive  to  in- 
vestors. 

3.  The   liability   of   owners   of   corporate   securities   is 

limited  to  their  investment — or  in  certain  excep- 
tional cases  to  a  larger  amount  bearing  a  fixed  pro- 
portion to  their  investment. 

4.  The  fact  that  the  ownership  and  management  are 

separated  makes  it  possible  to  procure  a  high  grade 
of  specialized  talent  for  managerial  positions, 
whereas  in  a  partnership  form  the  partners  them- 
selves usually  fill  these  positions;  in  many  lines  of 
business,  for  instance,  railroads  and  public  utilities, 
this  is  a.  striking  and  important  advantage. 


THE   CORPORATE   FORM  55 

5.  The  life  of  the  corporation  is  not  dependent  upon  the 
lives  and  activities  of  individuals;  the  duration  of- 
the  business,  therefore,  is  not  so  immediately  af- 
fected by  the  misfortunes  of  individuals. 
One  or  two  examples  will  indicate  how  these  advantages 
may  be  utilized  in  different  fields  of  operation.  Some  two 
years  ago  a  real  estate  operator  was  able  to  secure  control  of 
a  tract  of  land  of  about  600  acres,  situated  on  the  outskirts 
of  a  small  city  in  the  Middle  West,  which  proved  to  have  on 
it  some  valuable  beds  of  gravel  and  clay.  A  portion  of  the 
property  also  was  suitable  for  cutting  up  into  small  residence 
lots.  The  operator  paid  about  $300,000  for  the  property. 
He  estimated  that  with  proper  management  it  should  have  a 
value  of  over  $600,000,  yet  he  was  himself  unable  to  handle 
it  and  had  found  great  difficulty  in  securing  a  buyer.  Under 
these  conditions  he  was  advised  to  form  a  corporation,  issue 
bonds  and  capital  stock  which  could  be  sold  not  only  in  the 
near-by  city,  but  at  various  other  points,  and  thus  secure  for 
the  corporation  the  funds  with  which  to  go  ahead  with  the 
development  of  the  property.  The  plan  was  finally  adopted 
after  considerable  delay,  and  at  this  writing  is  in  process  of 
being  successfully  worked  out.  In  no  other  way  than  through 
the  organization  of  a  corporation  would  it  have  been  prac- 
ticable to  finance  this  undertaking. 

Advantage  of  Partnership  Incorporation 

A  somewhat  similar  instance  arose  in  connection  with  the 
dissolution  of  a  partnership  due  to  disagreement  and  personal 
friction  between  the  two  partners.  One  partner,  who  owned 
a  one-third  interest  in  the  business,  had  in  addition  about 
$50,000  and  desired  to  purchase  control.  The  other  partner 
was  willing  to  sell.  However,  the  total  value  of  the  business 
approximated  $300,000,  so  that  it  seemed  to  the  minority 
partner  impossible  to  buy  the  two-thirds  interest  he  wished 


56  FINANCE  AND  BUSINESS  ORGANIZATION 

with  but  $50,000.  The  solution  of  the  difficulty  was  found  in 
organizing  a  corporation  which  issued  notes,  preferred  stock, 
and  common  stock.  The  majority  partner  took  all  of  the 
notes  and  preferred  stock  and  a  portion  of  the  common  stock 
for  his  share ;  the  minority  partner  took  common  stock  alone 
and  received  enough  to  give  him  control  of  the  new  corpora- 
tion. The  corporate  form,  in  this  case,  proved  sufficiently 
elastic  to  enable  the  two  partners  to  adjust  satisfactorily  a 
situation  which  otherwise  would  have  led  to  costly  quarrels 
and  litigation. 

Under  personal  ownership,  either  by  individuals  or  by 
partnerships,  it  is  difficult  if  not  impossible  to  make  an  adjust- 
ment of  claims  upon  the  property  which  will  correspond  ex- 
actly to  the  various  shades  of  desire  for  management,  income, 
jand  risk.  The  corporate  form  is  peculiarly  well  fitted  for 
dividing  and  recombining  and  for  issuing  various  forms  of 
securities  in  such  a  way  as  to  bring  about  this  desired  corre- 
spondence. 

K  Advantage  of  Continuity  of  Ownership 

Again,  the  great  advantage  of  continuity  of  ownership  of 
a  business,  even  though  one  or  more  of  the  persons  jointly 
interested  may  die  or  withdraw,  is  often  of  paramount  im- 
portance. William  L.  Douglas,  it  is  stated,  owns  all  of  the 
common  stock  of  the  W.  L.  Douglas  Shoe  Company  of  Brock- 
ton, Mass.  An  arrangement  has  been  made,  however,  to 
appoint  three  trustees  who,  in  the  event  of  Mr.  Douglas'  death, 
would  carry  on  the  business  along  lines  that  he  has  marked 
out. 

Disadvsntagesof  the  Corporate  Form 

There  are  certain  minor  disadvantages  of  the  corporate 
form  which  may  in  some  cases  be  of  sufficient  importance  to 
prevent  the  adoption  of  this'  form.     The  first  and  most  im- 


THE   CORPORATE   FORM  ^j 

portant  is  simply  the  obverse  of  the  advantage  of  limited 
liability  for  the  shareholders.  Sometimes  this  advantage  in- 
volves placing  a  corresponding  lirmtation  on  the  credit  of  a  U 
corporation.  Let  us  suppose  the  case  of  a  wealthy  man  who 
desires  to  back  a  small  trading  concern.  If  he  becomes  a 
partner  in  the  concern,  thus  placing  behind  it  his  personal 
resources,  it  may  be  presumed  that  the  concern  will  have  all 
the  credit  that  it  can  properly  use.  On  the  other  hand,  if  he 
merely  takes  shares  in  a  corporation,  he  has  no  further  legal 
obligation  in  connection  with  the  business,  and  his  action  in 
some  circumstances  may  even  be  regarded  as  indicating  a  lack 
of  confidence.  Undoubtedly  the  corporate  form  does  lend 
itself  to  certain  kinds  of  swindling  operations.  It  has  been 
too  common  an  occurrence  for  unscrupulous  retailers  to  form 
a  corporation,  purchase  a  stock  of  goods  on  credit,  dispose 
of  the  goods,  transfer  the  money  to  themselves,  and  let  the 
corporation  go  into  bankruptcy.  Such  happenings  tend  to 
arouse  suspicion,  and  in  some  lines  of  business  may  lead  to 
undue  restriction  of  the  credit  of  small  corporations. 

Yet  this  result  is  not  unavoidable.  It  is  quite  possible  for 
any  shareholder  or  any  group  of  shareholders  who  desire  to 
do  so,  to  put  their  personal  indorsement  on  the  notes  of  a 
corporation  or  to  give  personal  guarantee  covering  payment  of 
the  corporation's  accounts.  In  so  doing  the  shareholders  would 
place  themselves  in  no  worse  position  than  if  they  were  to 
become  partners  in  the  business. 

The  second  disadvantage  is  governniental  control.     This   :i, 
has  already  been  alluded  to  in  speaking  of  the  reasons  why 
many  banking  and  brokerage  houses  are  not  incorporated. 
Financial  corporations  are  under  specially  close  supervision 
and  limitations  on  their  business. 

Most  states  require  all  corporations  to  submit  periodical 
and  detailed  reports  to  boards  or  ofBcials;  this  causes  con- 
siderable trouble  and  expense,  but,  as  necessitating  system  in 


58 


FINANCE   AND   BUSINESS    ORGANIZATION 


keeping  corporate  records,  it  is  sometimes  worth  all  the  labor 
it  entails. 

j^  The  third  minor  disadvantage  is  the  expense  of  organizing 
a  corporation.  This  expense  is  always  small  in  proportion  to 
the  capitalization.  The  organization  tax,  plus  the  filing  and 
incidental  fees,  of  a  $100,000  corporation  in  New  Jersey  is 
$35 ;  in  New  York  $65 ;  in  Delaware,  $25 ;  in  Maine,  $67 ;  and 
in  South  Dakota,  $18.  The  yearly  franchise  taxes  for  a  cor- 
poration of  this  size  are  in  New  Jersey  $100;  in  New  York, 
$150;  in  Delaware,  $10;  in  Maine,  $10;  in  South  Dakota, 
nothing.  Other  expenses,  such  as  lawyers*  fees  for  drawing 
up  the  corporation  charter,  and  the  like,  should  not  be  large. 
The  act  of  incorporation  is  nothing  more  than  routine  legal 
business. 

In  Canada,  a  Dominion  or  Federal  charter  is  issued  upon 
payment  of  a  fee  of  $250  for  a  capitalization  of  $200,000,  plus 
50  cents  for  every  $1,000  additional.  There  are  also  license 
fees  to  pay  to  the  government  of  the  province  in  which  the 
company  does  business,  which  may  amount  to  $200  ta  $350 
for  a  corporation  capitalized  at  $200,000.  In  all  other  modern 
countries,  the  fees  and  expenses  are  small  unless  an  attempt 
is  made  to  procure  a  special  charter  instead  of  operating  under 
the  general  Incorporation  or  Companies'  Act ;  in  that  case  the 
cost  may  become  very  high  indeed. 

L/  A  fourth  disadvantage  that  may  be  mentioned  is  the  fact 

that  the  charter  and  by-laws  of  a  corporation  give  a  certain 
fixedness  to  its  organization  and  its  powers  which  may  at 
times  prove  more  or  less  embarrassing.  If  these  documents, 
however,  are  wisely  drawn,  it  is  unlikely  that  there  can  be 
any  trouble  of  this  nature;  if  there  should  be  any  such  trouble, 
it  is  nearly  always  a  very  easy  and  simple  matter  to  make 
such  amendments  as  are  called  for. 

r  The  incorporation  under  state  laws  also  makes  it  necessary 

to  procure  certificates  allowing  the  corporation  to  operate  in 


THE   CORPORATE   FORM  59 

other  states  than  that  in  which  it  is  incorporated,  when  this  is 
desired,  and  this  usually  involves  some  expense. 

Corporations  doing  business  in  more  than  one  state  are  L>. 
also  liable  to  be  taxed  by  several  states  on  the  same  property, 
while  at  the  same  time  their  shareholders  may  also  be  paying 
taxes  on  their  respective  interests  in  the  stock,  making  a  double 
or  treble  tax  on  the  same  property. 

All  these  disadvantages,  it  is  clear,  are  for  most  corpora- 
tions of  slight  importance.  They  have  evidently  not  proved 
a  serious  obstacle  to  the  adoption  of  the  corporate  form,  for 
this  tendency  has  gone  on  year  by  year,  increasing  in  strength 
so  that  now  it  is  uncommon  for  enterprises  of  any  size,  with 
the  few  exceptions  noted  above,  to  be  organized  in  any  other 
form. 

Efficiency  of  Corporate  Organization 

Adam  Smith,  the  first  and  perhaps  the  greatest  of  econo- 
mists, was  extremely  skeptical  as  to  the  usefulness  of  the  large 
"joint-stock"  companies  which  in  his  day  were  just  beginning 
to  play  a  prominent  part  in  business  life.  ''Without  a  monop- 
oly," he  says,  "a  'joint-stock'  company,  it  would  appear  from 
experience,  cannot  long  carry  on  any  branch  of  foreign  trade, 
for  it  is  a  species  of  warfare  in  which  the  operations  are  con- 
tinually changing,  and  which  can  scarcely  ever  be  conducted 
successfully  without  such  an  unremitting  exertion  of  vigilance 
and  attention  as  cannot  long  be  expected  from  the  directors  of 
a  joint-stock  company."  Elsewhere  he  asserts  that  "negligence 
and  profusion  must  always  prevail  more  or  less  in  the  affairs 
of  a  *  joint-stock'  company." 

In  view  of  the  rapid  spread  of  the  joint-stock  or  corporate 
form  of  organization  and  the  immense  number  now  in  ex- 
istence, it  may  seem  at  first  glance  that  wise  old  Adam  Smith 
for  once  was  entirely  wrong.  Yet,  if  he  were  to  step  into 
twentieth  century  life  and  read  all  the  details  of  the  life  in- 


5o  FINANCE   AND   BUSINESS    ORGANIZATION 

surance  scandal,  the  New  Haven  Railroad  scandal,  the  Rock 
Island  Railroad  scandal,  and  the  various  other  unsavory 
messes  that  are  from  time  to  time  broug-ht  to  light,  he  would 
perhaps  not  be  easily  convinced. 

As  a  matter  of  fact,  it  is  probably  true  that  the  various 
advantages  cited  in  preceding  paragraphs  are  responsible  for 
the  wide-spread  adoption  of  the  corporation,  rather  than  any 
claim  it  can  reasonably  offer  to  superior  efficiency. 

There  are  some  features  of  corporate  organization  which 
are  no  doubt  an  improvement  in  respect  to  efficiency,  over 
any  other  forms  of  organization.  The  people  who  supply  the 
money  are  not  necessarily  the  ones  who  personally  manage 
the  enterprise ;  and  this  leaves  or  should  leave  an  opportunity 
to  engage  men  of  special  talent  as  managers.  The  custom  at 
one  time  was  to  select  one  of  the  largest  stockholders  as  the 
nominal  president  of  an  important  bank,  railroad  or  manu- 
facturing corporation,  but  this  has  now  been  largely  aban- 
doned in  favor  of  making  the  president  the  responsible  man- 
ager. Often  he  holds  only  a  few  shares  of  stock.  The  most 
important  or  influential  stockholder,  instead  of  becoming  presi- 
dent, is  more  frequently  made  chairman  of  the  board — a  posi- 
tion which  usually  pays  no  salary.  Furthermore,  it  is  at  least 
theoretically  true  that  the  creation  of  a  board  of  directors 
representing  the  owners  of  the  business  who  can  oversee  and 
check  or  stimulate  the  officers,  is  a  striking  gain.  On  the 
other  hand,  these  advantages  have  been  in  large  part  nullified  i 
by  the  selection  of  incompetent  or  overoccupied  directors. 
As  Adam  Smith  foresaw,  these  men  are  not  so  zealous  in  pro- 
tecting the  shareholders  as  they  are  in  advancing  themselves. 
Sometimes  responsibility  is  so  divided  that  it  rests  too  lightly 
on  the  shoulders  of  each  individual  director.  Hartley  Withers 
makes  the  interesting  comment  that  "the  real  business  of  most 
boards  is  done  by  a  small  minority  who  save  the  rest  from  the 
consequences  of  their  inexperience.     In  actual  practice  the 


THE   CORPORATE   FORM  6l 

notion  that  the  board  is  chosen  by  the  shareholders  or  is  really- 
representative  of  the  shareholders,  is  generally  a  delusion. 
The  board  either  forms  itself  or  is  formed  by  the  promotor 
and  fills  its  own  vacancies,  subject  only  to  the  purely  formal 
confirmation  of  the  shareholders.  The  officers  are  chosen 
by  the  board  or  by  one  another,  and  joint-stock  companies 
are  thus  governed  in  practical  fact  by  a  self-elected  oligarchy." 
This  is  true  not  only  in  London,  which  Mr.  Withers  has  in 
mind,  but  in  New  York,  Montreal,  Paris,  Berlin,  and  every 
other  part  of  the  world.  How  do  these  self -chosen  oligarchies 
work,  and  what  do  they  accomplish? 

Insolvency  of  the  Northern  Pacific 

During  most  of  the  period  1882- 1892,  Henry  Villard  was 
not  only  a  director  of  the  Northern  Pacific  Railroad  Company, 
but  was  president  of  the  company,  and  was  generally  regarded 
as  its  active  and  responsible  head.  Writing  in  1905,  however, 
in  his  "Memoirs"  and  no  doubt  wishing  to  excuse  himself  in 
part  for  the  insolvency  of  the  company  under  his  management, 
Mr.  Villard  said: 

In  1891  Mr.  Villard  ....  made  ....  his  last  official 
tour  of  inspection  of  the  main  line  and  principal  branches 
of  the  Northern  Pacific  ....  The  most  alarming  im- 
pression of  all  made  upon  him  was  the  revelation  of  the 
weight  of  the  load  that  had  been  put  upon  the  company 
by  the  purchase  and  construction  of  the  longer  branch 
lines  in  Montana  and  Washington,  which  he  then  dis- 
covered for  the  first  time  ....  They  represented  a  total 
investment  in  cash  and  bonds  of  not  far  from  $30,000,000, 
which  together  hardly  earned  operating  expenses.  The 
acquisition  and  building  of  these  disappointing  lines  had 
in  a  few  years  absorbed  the  large  amount  of  consoli- 
dated bonds  set  aside  for  construction  purposes,  which 
had  been  assumed  to  be  sufficient  for  all  needs  in  that 
direction  for  a  long  time.* 

•Quoted  in  Stuart  Daggett's  "Railroad  Reorganization,"  pp.  286-387, 


111 

ft 


62  FINANCE  AND   BUSINESS   ORGANIZATION 

It  IS  clear  that  Mr.  Villard,  whatever  may  have  been  his 
abilities  and  good  intentions,  was  not  devoting  sufficient  atten- 
tion to  the  business  of  this  corporation  to  qualify  himself  to 
direct  it. 

Management  of  the  Colorado  Fuel  and  Iron  Company 

Some  interesting  testimony  along  somewhat  the  same  line 
was  given  in  April,  19 14,  by  John  D.  Rockefeller,  Jr.,  who 
was  called  before  a  subcommittee  of  Congress  and  questioned 
as  to  his  control  over  the  Colorado  Fuel  and  Iron  Company. 
Mr.  Rockefeller  testified  that  his  father  held  40%  of  the  com- 
mon and  40%  of  the  preferred  shares  in  this  company.  He 
stated  that  he  was  a  member  of  the  board  of  directors,  but 
did  not  attend  meetings,  and  explained  that  he  had  every  con- 
fidence In  the  officers  of  the  company  and  kept  In  touch  with 
them  by  correspondence.  The  chairman  of  the  committee 
intimated  that  Mr.  Rockefeller  should  have  attended  an  im- 
portant meeting  in  October.  ''If  you  mean  that  I  should  have 
gone  to  Denver  to  attend  a  meeting  of  the  board  of  directors," 
was  the  reply,  "I  will  say  that  it  is  not  by  attending  the  board 
meetings  that  we  keep  in  touch  with  the  officers.  If  the  time 
comes  when  we  cannot  rely  on  the  officers  then  we  will  get 
somebody  else,  for  It  is  Impossible  for  us  to  attend  to  all  of 
these  things  ourselves,  and  we  have  got  to  get  the  ablest  men 
obtainable  to  act  for  us." 

Avoidance  of  Centralization 

~^  Another  criticism  frequently  levelled  against  the  efficiency 
of  large  corporate  organizations.  Is  based  upon  the  alleged 
inability  of  the  board  of  directors  sitting  at  the  head  office 
to  grasp  and  appreciate  conditions  at  the  branches.  Some- 
times, it  is  asserted,  with  regard  to  the  holding  companies 
operating  in  the  public  service  field,  that  the  supervision  ex- 
tended to  subsidiaries  is  Inadequate,  and  that  headquarters 


i 


THE  CORPORATE  FORM 


63 


lacks  personal  touch  with  the  local  situation  of  each  subsid- 
iary and  with  the  temper  of  the  public  that  is  being  served. 
In  some  cases  this  criticism  has  been  frankly  accepted  as  in 
part  valid,  and  the  remedy  has  been  found  by  securing  as 
directors  for  local  subsidiaries  the  strongest  and  best  men  in 
the  local  communities. 

Duties  of  Directors 

On  the  whole,  there  seems  to  be  reason  for  believing  that- 
corporate  organization  is  tending  to  increase  in  efficiency. 
Shareholders  and  the  investing  public  are  becoming  more  and 
more  acquainted  with  the  evils  of  careless  and  irresponsible 
direction  of  their  properties.  They  are  gradually  becoming 
acquainted,  also,  with  the  more  common  methods  of  exploita- 
tion and  are  insisting  upon  remedies.  The  only  real  and  per- 
manent remedy  for  corporate  inefficiency  lies  in  the  develop- 
ment of  higher  standards  of  business  morality.  Directors 
should  be  sincerely  convinced — as  perhaps  a  majority  of  di- 
rectors are — that  they  are  in  a  position  of  trusteeship  which 
they  have  no  right  to  accept  unless  they  intend  to  fulfil  all  it^ 
duties  vigorously  and  conscientiously,  and  that  next  to  actual- 
dishonesty,  the  most  serious  charge  that  can  be  made  against 
a  director  is  neghgence ;  in  fact  carelessness  in  handling  other- 
people's  money  is  itself  a  form  of  dishonesty.  When  this  truth 
is  so  widely  recognized  and  so  thoroughly  driven  home  that 
it  cannot  be  lightly  overlooked,  the  corporate  organization  will 
begin  to  achieve  its  proper  ratio  of  efficiency. 


Part  II— Capital 


CHAPTER    V 
OWNED  CAPITAL 

Owned  and  Borrowed  Capital 

The  capital  funds  used  in  business  enterprises  fall  into  two 
classes,  "owned  funds"  and  "borrowed  funds."  In  an  in- 
dividual proprietorship  or  in  a  partnership  the  distinction  is 
clear  and  easily  made.  The  total  value  of  the  assets  of  such 
a  business  is  represented  on  the  liability  side  of  the  balance 
sheet,  first  by  obligations,  or  "borrowed  funds,"  and  secondly 
by  proprietorship,  including  whatever  surplus  has  accumulated. 

In  a  corporation  the  distinction  between  "owned"  and 
"borrowed"  capital  is  not  always  so  clear,  nor  is  it  so  vital. 
The  corporation  itself  owns  all  of  its  assets  and  owes  not 
only  its  obligations;  but  also  its  capital  stock  and  surplus.  The 
creditors  and  the  shareholders  of  the  corporation  hold  varying 
amounts  and  degrees  of  claims  against  the  corporation  which 
almost  imperceptibly  shade  into  each  other.  The  distinction 
between  debenture  bonds  and  certain  types  of  preferred  stock 
is  slight.     Indeed,  it  would  be  difficult  to  name  any  dividing 

K^'*^e  which  clearly  separates  the  shareholders  from  the  obliga- 
n  holders,  or  creditors,  of  a  corporation. 
Nevertheless,  we  may  in  general  follow  the  customary  line  »^ 
distinction  and  say  that  most  bonds,  notes,  accounts  pay- 
le,  and  other  obligations  of  a  corporation,  may  be  regarded 
as  representative  of  borrowed  capital,  and  most  shares  of 
capital  stock  may  be  regarded  as  representative  of  owned 
capital. 

65 


to 


g5  CAPTTAL 

Some  companies  have  practically  nothing  hut  owned 
capital;  that  is  to  say,  tli-Ii  Imim.  in  -  .nc  ahiiost  nil.  Or- 
dinarily, the  only  corj  "i  m  -n  m  tin  ondition  are  those 
which  have  just  started,  '^i  ili"  *  vlnli  ik  -mall  and  strug- 
gling and  liave  not  the  credit  which  would  enable  them  tc 
borrow  even  on  short  time.  Once  in  a  while,  however,  we 
find  a  large  corporation  which  follows  the  same  policy.  I'or^ 
instance,  the  W.  L.  Douglas  Shoe  Company  carries  on  tlu 
liability  side  of  its  balance  sheet  only  common  stock,  prcferrc< 
stock,  and  a  small  amount  of  current  accounts  payable. 

A  small  enterprise  is  usually  conducted  on  tlie  owned  capi^ 
tal  of  the  proprietor  or  the  partnership,  with  possibly  recourse 
to  the  bank  for  short-term  loans  from  time  to  time.  Also, 
the  proprietor  or  one  of  the  partners  will  sometimes  borrc 
money  for  the  business  on  his  personal  note,  secured  perhapi 
by  mortgage  of  his  real  estate,  and  thus  increase  his  invest 
mcnt  and  the  amotmf  of  the  partnership's  owned  capital  bj 
the  amount  so  secured. 

When  there  is  a  single  proprietor,  he  may  perhaps,  whet 
additional  capital  is  required,  secure  this  by  the  admissioi 
of  a  partner  with  capital.  A  p.-nlnrrsbij)  mij(ht  accomi>lish  thi 
same  result  by  .'i(l<lini^  ;moib(i  |Mi  iijcr.  It  is  possible  at  timci 
for  firms  l"  ^'un  kMiIkmiJ  <  i|.ital  by  admittin^^  special  oi 
limited  paiin-  i  ,  who  take  ii"  m  live  part  in  the  business  bu 
who  invc',!  (.ipii.il  :iii(l  Ii.im  m  ilie  profits.  In  many  statei 
tii(*  '.i.iiiiic.  |.i<.v)<lc  ih.ii  iIk  |M(i;il  or  limited  partner  shal 
not  be  liable  lo  <  irdiioi  ,  <.!  ihc  ium  beyond  his  investment. 

Wli'  II  111.  iiiiii.  i\>,  \i<,\  piovidc  for  limilc'd  partnerships 
ihr  ■:iiii.  Mid  iii.i\  JM  .i<  ( .»!ii|.li  lied  by  .'idiiiiltiii^  a  dormant 
mImiI  ,  '.I  l<  I  |,ii|..  p.ii  111,  I  '1  he  doi  )ii;inl  purtiicr  takes  no  pai 
in  lli<  I. II  MM  ,  .111.1  11  II  lily  avoids  publicity  as  to  his  connec 
tion  wilh  iIk  l.n  hk  ,,.  Jf  known  \<>  Im  .i  partner,  he  may  b( 
held   for  llie  p.iiUiLiship  obli|^.ilioiis,  like  any  other  membci 

•d    lli(     liUll. 


OWNKD   CAriTAL 


67 


It  is,  of  course,  always  possil)lc  for  a  sole  proprietorship 
or  p.'irtncrsliip  to  incorpi^ratc  aiul  issue  stock;  if  it  (1(h\s  so, 
its  capital  probloins  arc  then  tlie  sauie  as  those  of  auy  other 
corporation.  Many  small  l)usiuesses  have  been  incorporated, 
nul  most  Inisitu"  c^  wIumi  \\\c\  increase  to  a  certain  point 
incorporate,  on  .icct>uni  oi  (he  lacility  given  by  the  corporate 
forms  in  securing  acldilional  capital. 

Stocks  and  Shares 

The  title  of  this  secti(Mi  is  borrowed  from  an  exceptionally 

readable  book  by  Hartley  Withers,  to  which  reference  is  made 

below.    At  first  glance  the  combination  of  words  in  the  title 

seems  to  the  Americ.m  u-.uKm-  so  nuich  nonsiMisi\   foi   in  ilie 

United  States  we  arc  .ucustomcd   to  applv   ilu-   (wo   w^uds 

"stocks"  and  "shares"  ahm^st  indiscrimin.urU .  l>n(li  nu\iniii>; 

the  imits  ot  .1  r.M  jMM.iii.Mi':.  ^-wiu-vl  v-.iiMt.il      \\\-  vK-ii\o  our 

meaning  (>l  i\\c  woul  ">(oik"  m  ii>^  im.uui.il  .-rust'   houi  its 

original  nicaning  o{  si>mclhing  bciiu-d  up  Ulc  .1   .s(.uk;  this 

i    the  sense  in  which  it  is  used  in  the  phrase  **s(ock  in  trade." 

\dam  Smith  uses  (he  \\(Mt!  (o  me.m  \\\c  e.ipit.il  i^i  a   firtn  or 

eompany,  and  this  uieaiim;:  Ii.i->   -ni\i\eJ  m  (he  lhu(e<l  S(.i(es, 

but  not  in  l\ur(>[H\     In  l'ii.:;I.iuJ.  :4o.k  1  >  <hstinguished  irom 

shares  by  the  fact  that  it  is  divisible  iti(o.  .nul  dm  ui.ible  in, 

odd  and  varying  am(>un(  ^   r.meju;;    from   tens   ol    (hous.nuls 

down  to  a  penny.     At   tlie  iMi;;ni.!l  subsi-tiptiou  anyone  uuiy 

take  any  o(U\  amoutU  o(  tlu-    >(. uk  (h.u   he  e.ires  for.     The 

Stock  Kxchange  calls  the  mm  >ini(  (h.u  is  not  divisible  by  one 

htmdrcd,  a  "broken  le>t  "     Siork   is  cpioted  on  the  London 

^Stock  l^xchange  at  so  uiueh  pej  t  \oo.  Shares  are  distinguished* 

^Bom  stock  by  the  fact  that  they  are  expressed  in  terms  of 

^fefinite  amounts  .uul  avc  nuh visible.     There  are,  however, 

une  few  English  coiup.iuies  ihat  will  transfer  fractions  of 

hares.* 

•Hartley  Wlthert'  "Stocki  and  Shtws,'*  pp.  33^ 


68  CAPITAL 

In  the  United  States  there  is  no  security  which  corresponds 
to  what  the  EngHsh  call  stock.  The  owned  capital  of  any 
corporation  is  always  represented  by  an  issue  of  shares,  each 
share  being  of  a  uniform  amount  with  the  other  shares  in 
the  same  series,  and  of  like  standing  and  rights.  In  both 
countries  the  capital  stock  of  the  corporation  may  be  of  two 
or  more  classes,  which  in  this  country  are  usually  called  "com- 
mon" and  "preferred."  In  England  the  more  usual  titles  are 
"ordinary"  and  "preference,"  and  in  that  country  there  is  a 
much  larger  variety  of  shares  than  we  have  here.  There  are 
"deferred"  shares,  "founders'  "  shares,  "deferred  ordinary" 
shares,  "preferred  ordinary"  shares,  and  so  on  almost  indef- 
initely. In  this  country,  after  we  have  used  the  terms  "com- 
mon" and  "preferred"  we  usually  fall  back  on  such  matter- 
of-fact  titles  as  "first  preferred,"  "second  preferred,"  "third 
preferred,"  and  the  like. 

Transfer  of  Stock 

Shares  of  stock  are  ordinarily  represented  by  certificates 
'issued  by  the  corporation,  each  one  of  which  states  on  its  face 
how  many  shares  it  represents,  to  whom  it  is  issued,  and  the 
legal  conditions,  if  any,  under  which  the  shares  are  issued. 
These  certificates  are  transferable  and  negotiable  when  in- 
dorsed in  blank  by  the  person  to  whom  they  were  originally 
issued.  They  may  pass  from  hand  to  hand,  be  used  as  col- 
lateral for  bank  loans,  and  be  transferred  many  times,  before 
being  finally  sent  in  to  the  corporation  for  transfer — that  is, 
in  order  that  the  name  of  the  new  owner  of  the  certificate 
may  be  entered  as  a  stockholder  and  a  new  certificate  may 
be  sent  to  him.  This  transfer  on  the  books  of  the  corporation 
is  usually  attended  to  before  the  transfer  books  are  closed  in 
anticipation  of  a  dividend.  Inasmuch  as  dividends  are  paid  to 
stockholders  of  record  as  they  are  registered  in  the  books  of 
the  corporation,  it  is  desirable  that  the  n^w  owner  of  a  cer- 


OWNED   CAPITAL 


69 


tificate   should  be   careful   to   see   that  his   name  is   entered 
promptly. 

The  larger  corporations  entrust  the  issuing,  handling,  and  ■ 
checking  of  their  certificates  of  stock  to  a  registrar  and  a 
transfer  agent,  both  of  which  usually  are  trust  companies.  It- 
is  the  business  of  the  transfer  agent  to  see  to  it  that  the  record 
of  stockholders  is  kept  up  to  date,  and  that  old  certificates  are 
cancelled  and  new  ones  issued  as  called  for.  It  is  the  business 
of  the  registrar  to  check  the  issuance  and  see  to  it  that  no  more 
are  put  out  than  have  been  authorized  and  issued  for  property. 
This  practice  of  having  a  registrar  to  check  the  transfer  agent, 
is  an  outgrowth  of  the  era  of  wild  speculation  on  the  New 
York  Stock  Exchange  in  the  seventies  and  eighties,  when  the 
leaders  were  Jay  Gould,  James  Fisk,  and  Daniel  Drew.  In 
their  operations  these  men  were  not  trammeled  by  any  legal  or 
moral  restraints.  If  it  suited  them  to  set  the  printing  presses 
going  and  secretly  to  put  out  large  new  issues  of  unauthorized 
securities,  they  did  so,  and  were  able,  apparently,  to  keep 
within  the  bounds  of  the  law.  To  guard  against  activities 
such  as  these  and  to  make  their  stocks  more  readily  salable, 
the  older  and  more  conservative  corporations  started  the  prac- 
tice of  engaging  independent  registrars. 

A  Corporation  Dealing  in  Its  Own  Stock 

A  question  which  often  arises  is  whether  or  not  a  cor- 
poration may  acquire  or  deal  in  its  own  stock.  Courts  in 
New  York,  California,  Wisconsin,  and  other  jurisdictions 
have  decided  in  recent  years  that,  in  the  absence  of  statute 
to  the  contrary,  a  corporation  may  deal  in  its  own  stock,  pro- 
vided the  purchase  or  sale  is  made  in  good  faith  and  without 
injury  to  creditors.  However,  the  statutes  of  many  states 
specifically  forbid  this  practice.  It  is  obviously  objectionable 
when  it  is  so  used  as  to  bring  about  a  reduction  in  outstanding 
capital  stock  without  due  process  of  law,  or  when  it  is  used 


I 


70 


^ 


CAPITAL 


as  a  method  of  paying  off  certain  favored  shareholders  at  the 
expense  both  of  the  other  shareholders  of  the  company  and 
of  the  creditors. 

"Common  Stock"  or  "Ordinary  Shares" 

In  the  United  States  we  speak  of  "common  stock";  in 
England  they  use  the  term,  "ordinary  shares."  The  two  ex- 
pressions are  practically  identical  in  meaning;  both  refer  to 
shares  which  have  no  special  privileges  or  rights  but  which  are 
entitled  to  whatever  capital  or  income  remains  after  prior 
claims  have  been  satisfied.  One  verbal  exception  to  this  gen- 
eral statement  may  be  noted.  In  English  usage  there  are 
sometimes  "deferred"  or  "deferred  ordinary"  shares,  which 
are  inferior  in  claims  to  the  so-called  ordinary  shares.  In 
this  case  the  shares  that  are  called  ordinary  are  really  "pre- 
ferred." Once  in  a  while  the  same  practice  is  found  in  the 
United  States.  For  instance,  the  Denver  Reservoir  Irrigation 
Company  has  three  classes  of  common  stock,  which  are  known 
respectively  as  "A,"  "B,"  and  "C"  common-  Voting  power 
is  vested  only  in  classes  "A"  and  "B,"  which  accordingly  are 
given  preference  in  this  respect  over  the  "C"  class^  Cus- 
tomarily, however,  common,  or  ordinary,  shares  are  all  of  the 
same  class  and  represent  the  final  equity  in  the  enterprise  after 
prior  claims  have  been  made. 

The  simplest  case  of  capitalization  arises  when  a  corpora- 
tion has  outstanding  only  one  class  of  stock,  and  no  notes  or 
bonds.  The  laws  of  several  states  specifically  provide  that 
in  the  absence  of  any  special  preference  for  certain  classes  of 
stock,  all  stock  shall  be  of  one  class  and  shall  be  known  as 
•*  common  stock.  Any  stock  that  is  set  aside  and  given  special 
privileges  has  still  all  the  rights  of  common  stock,  except 
so  far  as  these  are  taken  away  or  limited  by  statute  or 
charter  provision.  We  shall  see  that  there  is  no  rule,  or 
even  established  custom,  as  to  the  rights  and  privileges  of 


OWNED   CAPITAL  7 1 

so-called  preferred  stock.     The  common  stock  is  entitled  to-^ 
every  privilege  that  is  not  specifically  taken  away  from  it. 

Preferred  Shares 

Although  preferred  shares  are  entitled  only  to  what  is 
specifically  granted  to  them,  some  customs  have  become  fairly 
well  established.  In  the  United  States  nearly  all  industrial 
preferred  shares  bear  cumulative  dividends  at  the  rates  of  6%, 
7%,  and  8%,  a  great  majority  receiving  7%.  Just  why  these 
percentages  should  have  been  chosen  is  somewhat  difficult  to 
say.  Probably  the  best  answer  is  to  be  found  in  the  statement 
that  high-grade  preferred  shares  have  been  selling  for  several 
years  on  about  a  7%  basis;  that  is  to  say,  if  they  are  6% 
shares  they  sell  at  about  $86  for  each  $100  shares;  if  they 
are  7%  shares  they  sell  at  about  par;  and  if  they  are  8% 
shares  they  sell  at  about  $114  for  each  $100  share.  Inasmuch 
as  shares,  when  they  have  a  market  value  of  or  near  par,  are 
more  convenient  and  more  salable  than  would  otherwise  be 
the  case,  there  is  an  advantage  in  making  their  preferential 
dividend  7%.  There  is,  however,  nothing  fixed  in  this  custom. 
If  the  general  level  of  prices  changes  so  that  good  industrial 
preferred  shares  begin  to  sell  at  par  on  a  6%  basis,  we  may 
expect  to  see  the  customary  rate  changed  to  6%. 

The  preferred  dividend  may  be  either  "cumulative"  ort 
"non-cumulative.'*  A  cumulative  dividend  is  one  which  carries 
over  from  year  to  year;  that  is  to  say,  in  case  the  profits  are 
not  sufficient  to  pay  the  full  preferred  rate  in  any  given  year, 
the  unpaid  dividends  will  remain  as  a  prior  claim  to  be  paid 
in  some  succeeding  year  before  dividends  are  declared  on 
the  common  shares.  Non-cumulative  dividends  give  the  pre- 
ferred shares  a  prior  claim  for  dividends  each  year;  but  in 
case  these  profits  are  not  sufficient  to  meet  the  claims,  or  for 
other  reasons  dividends  are  not  declared,  no  obligation  rests 
upon  the  corporation  to  make  up  the  deficiency  in  later  years. 


72 


CAPITAL 


At  one  time  most  preferred  shares  were  non-cumulative. 
But  as  such  they  have  been  found  unsatisfactory  because  of 
the  conflict  of  interest  between  the  common  and  the  preferred 
shareholders  as  to  the  payment  of  preferred  dividends  each 
year.  It  is  obviously  to  the  advantage  of  the  common  share- 
holders to  defer  dividends  on  the  preferred  shares  as  long  as 
possible,  since  the  cumulating  profits  inure  directly  to  the 
benefit  of  the  common  stock.  It  is  a  simple  matter  of  account- 
ing procedure  to  use  whatever  profits  accrue  to  the  corpora- 
tion to  increase  assets  and  to  pass  preferred  dividends,  until 
sufiicient  profits  have  accumulated  to  pay  equal  dividends  to 
both  preferred  and  common  stock.  There  is  plenty  of  op- 
portunity not  merely  for  unfair  diversion  of  funds  away  from 
the  preferred  shareholders,  but  also  for  the  expression  of 
differences  of  opinion  as  to  whether  dividends  are  honestly 
withheld.  .  ? 

Non-cumulative  preferred  stock,_Ls  as  stated,  undesirable. 
It  is,  in  fact,  a  standing  invitation  to  the  directors,  unless  their 
ethical  standards  are  high,  to  administer  the  corporate  finances 
to  the  advantage  of  the  common  stockholder.  Profits  that 
might  very  properly  have  been  applied  to  the  preferred  div- 
idends are  diverted  into  improvements  or  developments. 
These  redound  to  the  ultimate  advantage  of  the  company,  but 
meanwhile  stand  in  the  way  of  dividends  on  the  non-cumula- 
tive preferred  stock  until  the  company  has  reached  a  point 
where  common  and  preferred  stock  dividends  are  both  pos- 
sible. The  preferred  stockholder's  dividends  for  this  period 
are  absolutely  lost  as  far  as  he  is  concerned.  The  company 
has  profited  at  his  expense.  The  directors  might  properly 
have  paid  them  if  they  would,  but  decided  in  favor  of  the 
common  stockholder. 

If  investors  were  wise  there  would  be  no  sale  for  the  non- 
cumulative  stock,  for  there  is  no  legal  way  for  the  holder 
of  such  stock  to  prevent  the  directors  postponing  dividends 


OWNED   CAPITAL 


73 


until  the  common  stockholders  can  share  equally  or  even  re- 
ceive more  than  do  the  holders  of  preferred  stock. 

It  is  to  be  noted  that  if  the  preferential  dividend  is  to  be 
non-cumulative,  this  fact  must  be  clearly  expressed  in  the 
charter  provisions  by  which  the  stock  is  authorized.  Where 
not  so  expressed  the  courts  have  held  the  preferential  dividends 
to  be  cumulative  and  payable  in  full  out  of  the  first  profits 
before  anything  is  received  by  the  common  stock.  The  cumu- 
lative feature  of  preferred  stock  is,  however,  for  the  sake  of 
security  and  definiteness  usually  covered  by  express  provision. 

On  the  other  hand,  cumulative  dividends  have  an  uncom- 
fortable habit  of  piling  up,  and  may  become  in  the  course  of 
a  few  years  so  serious  a  burden  as  to  leave  no  reasonable  hope 
for  dividends  on  the  common  shares.  Such  a  situation  might 
interfere  with,  or  prevent  entirely,  additional  financing  were 
it  needed.  It  is  not  at  all  uncommon  in  corporate  experience 
for  a  company  to  go  through  several  years  of  depression  and 
limited  income,  and  then,  through  good  management  or  by 
some  fortunate  circumstance,  suddenly  enter  upon  a  period 
of  prosperity.  Naturally,  the  common  shareholders,  having 
received  no  dividends  through  the  "lean"  years,  feel  that  they 
are  entitled  to  some  recompense.  If  a  large  amount  of  un- 
paid dividends  on  cumulative  preferred  shares  stands  in  the 
way,  it  is  now  customary  to  try  to  find  some  way,  under  the 
conditions  stated,  of  "funding"  these  unpaid  dividends,  thus 
satisfying  both  the  common  and  the  preferred  shareholders. 
The  "funding"  of  the  unpaid  dividends  is  accomplished  by 
issuing  securities  of  some  kind  to  the  preferred  shareholders 
in  exchange  for  their  dividend  claims. 

Shares  may  be  preferred  not  only  as  to  dividends,  but  also- 
as  to  assets;  that  is,  in  case  of  dissolution  or  insolvency,  the 
full  par  value  of  the  preferred  shares  is  to  be  paid  before 
any  payment  is  made  on  account  of  the  common  shares.    We 
shall  see,  when  we  come  to  consider  reorganization,  that  as 


74 


CAPITAL 


a  matter  of  fact  going  corporations  are  seldom  sold  or  entirely 
liquidated  and  the  assets  distributed  among  the  various  security 
holders.  It  is  usual  to  bring  about  a  reorganization  in  which  1 
the  claims  of  each  class  of  securities  are  so  readjusted  that 
they  may  all  be  met  by  the  corporation.  Hence  the  prior 
claim  of  preferred  shares  upon  assets  is  not  to  be  taken  too 
literally,  but  is  to  be  regarded  rather  as  a  legal  point  of  ad- 
vantage in  securing  the  best  possible  terms  in  case  reorganiza- 
tion should  become  necessary.  From  this  point  of  view,  the 
preference  as  to  assets  is  of  considerable  importance. 

It  is  well  to  reiterate  that  the  preferences  granted  to  pre- 
ferred shares  are  no  more  than  are  distinctly  specified,  and 
that  these  preferences  may  consist  not  only  of  prior  claims 
3 as  to  dividends  and  a_ssets,  but  of  prior  claims  as  to  voting. 
For  instance,  the  preferred  shares  of  the  Rock  Island  Com- 
pany of  New  Jersey  (the  former  holding  company  for  the  Chi- 
cago, Rock  Island  and  Pacific  Railway)  were  entitled  to  elect 
a  majority  of  the  directors  of  that  company.  It  is  more 
usual,  however,  for  preferred  shares  to  have  no  vote,  on  the 
theory  that  the  responsibility  for  conducting  the  corporation 
should  rest  with  the  non-preferred  shares,  which  take  the 
greater  part  of  the  risk. 

In  every  case  in  which  preferred  shares  are  under  con- 
sideration, it  is  necessary  to  go  to  the  charter  or  by-laws  and 
find  out  exactly  the  nature  of  the  preference.  In  1901  there 
was  a  struggle  between  the  Hill-Morgan  party  on  the  one 
side  and  the  Harriman-Kuhn,  Loeb  party  on  the  other,  for 
control  of  the  Northern  Pacific  Railroad  Company,  in  the 
course  of  which  the  Hill-Morgan  party  secured  a  majority  of 
the  common  shares,  and  the  Harriman-Kuhn,  Loeb  party  a 
majority  of  the  preferred  shares  together  with  enough  of  the; 
common  shares  to  give  them  a  majority  of  the  entire  outstand- 
ing stock.  Inasmuch  as  both  common  and  preferred  shares] 
had  voting  rights,  it  seemed  clear  that  the  victory  remained] 


OWNED   CAPITAL 


75 


with  the  Harrlman-Kuhn,  Loeb  group.  Unfortunately  for 
their  calculations,  however,  the  charter  of  the  company  gave 
the  common  shareholders  a  right  at  any  time  to  redeem  the 
preferred  shares  at  par.  This  right  the  Hill-Morgan  party 
exercised  and,  through  the  control  thus  given  them  by  a  clause 
which  had  apparently  been  overlooked  by  their  opponents, 
obtained  the  upper  hand. 

Origin  and  Uses  of  Preferred  Shares 

Preferred  shares  came  into  popularity  in  the  United  States 
chiefly  on  account  of  their  influence  in  railroad  reorganizations. 
It  was,  and  is  still,  customary  in  severe  reorganizations  to  cut 
down  the  fixed  obligations  of  the  corporation  by  compelling 
some  of  the  junior  bondholders  to  accept  preferred  shares  in- 
stead of  their  bonds.  By  making  this  exchange,  the  former 
bondholders  retain  their  claims  upon  the  income  of  the  cor- 
poration, but  the  claim  is  made  simply  a  preference  instead 
of  a  positive  obligation.  Except  in  reorganizations,  preferred 
shares  have  been  very  little  used  in  the  United  States  by  rail- 
road corporations. 

An  entirely  different  use  has  been  found  for  them,  how- 
ever, in  connection  with  large  industrial  corporations.  It  has 
become  customary  to  represent  the  tangible  assets  and  the 
current  earning  power  of  corporations  by  bonds  and  preferred 
shares,  and  to  represent  the  intangible  assets  and  expected 
income  by  common  shares.  Nearly  all  of  the  large  industrial 
corporations  formed  in  the  last  twenty  years  have  followed 
this  policy.  One  of  the  striking  features  of  the  stock  market 
during  the  last  five  years  has  been  the  successful  floating  of  a 
large  number  of  preferred  share  issues  by  the  smaller  indus- 
trial corporations.  Sometimes  these  shares  are  sound,  some- 
times unsound.  In  either  case  it  seems  to  be  fairly  easy  to 
dispose  of  them;  the  buying  public  has  evidently  been  edu- 
cated to  like  and  approve  industrial  preferred  shares. 


76  CAPITAL 

Preferred  shares  are  sometimes  used  also  to  distribute  vot- 
ing power  in  such  a  way  as  to  give  control  to  a  comparatively 
small  group.  The  Rock  Island  preferred  shares,  referred  to 
above,  were  of  this  kind. 

In  the  smaller  corporate  organizations,  preferred  stocks 
are  often  used  to  make  the  adjustments  necessary  in  the  in- 
corporation of  partnerships.  If  it  is  desired  to  give  equality 
of  voting  right,  the  partner  having  an  excess  of  capital  is  given 
a  similar  excess  of  stock  in  non-voting  preferred  stock.  Or, 
common  stock  may  be  given  to  those  who  have  the  manage- 
ment, and  preferred  stock  may  be  given  to  those  who  are  to 
.retire  from  the  business.  By  means  of  the  two  kinds  of  stock, 
almost  any  desired  difference  of  investment  or  power  of  con- 
trol may  be  secured. 

Protection  of  Preferred  Shares 

It  has  already  been  noted  that  in  modern  corporations  th( 
distinction  between  owned  capital  and  borrowed  capital  is 
sometimes  shadowy.  Preferred  shares,  for  instance,  are  some- 
times protected  and  subject  to  redemption  in  such  a  way  as  to 
bring  them  almost,  if  not  wholly,  into  the  same  class  as  junior 
bonds.  It  is  very  common  practice  for  a  company  to  reserv( 
the  right  to  redeem  preferred  shares,  usually  at  a  premium 
varying  from  5%  to  20%  or  more.  The  decision  of  the 
matter,  however,  rests  with  the  corporation.  Further  than  this, 
many  companies  make  redemption  obligatory  and  even  provide 
for  the  building  up  of  sinking  funds  for  this  purpose,  just 
as  in  the  case  of  sinking  fund  bonds.  The  California  Petro- 
leum Corporation,  for  example,  sets  aside  five  cents  on  each 
barrel  of  petroleum  sold,  to  redeem  its  preferred  shares.  The 
May  Department  Stores,  the  Studebaker  Company,  and  the 
Underwood  Typewriter  Company  all  have  sinking  funds  foi 
this  purpose.  The  provision  in  the  charter  of  the  Underwooc 
Typewriter  Company  reads  as  follows: 


OWNED   CAPITAL  77 

There  shall  be  set  apart  from  the  net  profits  of  the 
Company  at  the  rate  of  not  less  than  $100,000  per  annum, 
a  fund  to  be  known  as  "Special  Surplus  Capital  Reserve 
Account,"  which  shall  be  made  and  kept  going  at  the  rate 
of  $100,000  per  annum  for  each  year  before  any  divi- 
dend shall  be  paid  on  the  common  stock,  and  after  the  ex- 
piration of  three  years  from  the  date  of  incorporation  of 
the  Company  said  Special  Surplus  Capital  Reserve  Account 
shall  be  used  annually  in  the  purchase  and  retirement  of 
said  preferred  stock  at  the  lowest  price  at  which  the 
same  may  be  obtainable,  but  in  no  event  exceeding  a  pre- 
mium of  25%  over  and  above  the  par  value  thereof.  Such 
purchases  may  be  made  at  the  option  of  the  Company 
either  at  a  public  or  private  sale,  and  all  preferred  stock 
so  acquired  shall  be  cancelled. 


It  is  also  becoming  a  more  and  more  prevalenr  custom  to« 
protect  preferred  stock  by  specific  provisions  as  to  percentages 
of  current  liabilities  to  current  assets,  of  net  surplus  to  capital, 
of  dividends  to  current  surplus,  and  the  like.  The  Canadian 
Inter-Lake  Line  is  required  by  its  charter  to  establish  a  cumu- 
lative reserve  fund  equal  to  50%  of  the  outstanding  preferred 
stock,  and  to  maintain  the  fund  by  setting  aside  out  of  earn- 
ings an  amount  equal  to  at  least  3%  par  value  on  the  outstand- 
ing preferred  stock.  In  the  case  of  the  Moline  Plov^  Com- 
pany, the  net  quick  assets  must  always  equal  at  least  $140 
per  share  of  first  preferred.  Montgomery,  Ward  and  Com- 
pany provide  that  no  additional  preferred  beyond  the  present 
issue  can  be  put  out  unless,  after  such  issue,  the  net  quick 
assets  shall  equal  at  least  120%  of  the  outstanding  preferred. 
The  Grif^n  Wheel  Company  has  a  number  of  detailed  provi- 
sions. Additional  issues  (after  the  original  issue)  of  its  pre- 
ferred stock  cannot  be  put  out  up  to  more  than  66  2/3%  of 
the  cost  of  improvements,  extensions,  or  increased  working 
capital.  Common  dividends  may  not  be  increased  to  more 
than  7%  unless  the  net  tangible  assets  are  at  least  50%  of  the 


78 


CAPITAL 


preferred  shares;  even  then,  the  common  may  get  only  one- 
half  the  surplus  earnings  above  the  preferred  and  previous 
common  dividends.  When  the  tangible  assets  rise  to  200%, 
the  net  quick  assets  being  50%  of  the  preferred,  the  directors 
of  this  company  may  declare  such  dividends  on  the  common 
"as  may  be  deemed  prudent." 

A  form  of  protection  given  by  many  companies  is  the 
proviso  that  the  preferred  shareholders  shall  automatically  ob- 
tain control,  or  partial  control,  over  the  directorate  of  the  cor- 
poration in  case  their  claims  are  not  met.  It  is  customary  to 
give  the  preferred  the  power  to  veto  an  increase  of  bonds  or 
of  preferred  stock.  The  Wisconsin  Central  Railroad  Com- 
pany provides  that  in  case  of  failure  for  two  successive  years 
to  pay  4%  dividends  on  its  preferred,  the  preferred  share- 
holders shall  have  the  right  to  elect  a  majority  of  the  directors. 
In  the  American  Smelters  Securities  Company,  the  preferred 
shareholders  are  permitted  to  vote  if  dividends  for  one  year 
remain  unpaid.  The  William  Carter  Company  gives  both  the 
preferred  and  the  common  shares  equal  voting  power,  except 
that  if  there  is  default  in  four  successive  quarterly  dividends 
on  the  preferred,  or  if  the  net  quick  assets  for  one  year  remain 
at  less  than  the.  par  value  of  the  preferred  shares  outstanding, 
the  preferred  becomes  the  sole  voting  stock.  The  American 
Sumatra  Tobacco  Company  provides  that  if  unpaid  dividends 
accumulate  above  14%,  the  preferred  shareholders  shall  have 
the  right  to  elect  a  majority  of  the  board.  The  International 
Motor  Company  provides  that  if  the  preferred  stock  fails  to 
receive  dividends,  it  shall  obtain  the  sole  voting  power.  The 
American  Rolling  Mill  Company  gives  its  6%  preferred  stock 
the  right  to  vote  only  when  three  successive  dividend  periods 
have  been  passed. 

All  of  these  provisions  appear  to  be  equitable,  although 
the  mere  grant  of  voting  power  to  preferred  shareholders,  if 
the  common  shares  still  retain  control  of  a  corporation,  may 


OWNED   CAPITAL 


79 


prove  to  be  a  concession  of  only  slight  importance.  If  it  is 
expected  and  seriously  intended  that  the  dividends  on  pre- 
ferred shares  shall  be  paid  regularly  year  after  year,  then  it 
would  seem  only  fair  that  the  common  shareholders,  if  they 
should  fail  to  live  up  to  this  expectation,  should  forfeit  control 
and  give  the  preferred  shareholders  a  chance  to  see  what  they 
can  accomplish.  It  may  be  objected  that  an  arrangement  of 
this  kind  would  involve  the  possibility  of  shifting  the  control 
from  one  set  of  shareholders  to  another  from  year  to  year,  a 
practice  which  would  be  fatal  to  the  interests  of  both  classes. 
The  answer  to  this  objection  is  to  be  found  in  the  fact  that 
whatever  minor  conflicts  of  interest  may  exist  between  the  pre- 
ferred and  the  common  shareholders,  both  are  likely  to  do  all 
they  can  to  build  up  the  corporation,  and  this  tendency  would 
probably  not  prove  serious.  It  may  be  further  suggested  that 
preferred  shareholders,  after  all,  bear  a  considerable  part  of 
the  risk  in  most  corporations,  and  ought  from  the  beginning 
to  have  at  least  a  small  share  in  the  management ;  they  could 
be  given  complete  control  in  the  event  of  default  in  the  pay- 
ment of  preferred  dividends. 

In  Canada  it  is  unusual  to  deprive  preference  shareholders 
of  their  customary  right  to  vote  upon  their  shares.  The  Com- 
panies Act  of  the  Dominion  states  that: 

Holders  of  shares  af  preference  stock  shall  in  all 
respects  possess  the  rights,  and  be  subject  to  the  liabili- 
ties, of  shareholders  within  the  meaning  of  this  Act, 
provided  that  in  respect  of  dividends  and  in  any  other 
respect  declared  in  by-laws  as  authorized  by  this  Act, 
they  shall,  as  against  the  ordinary  shareholder,  be  entitled 
to  preferences  and  rights  given  by  such  by-laws. 

It  is  plainly  implied  here  that  preferred  shareholders  are  en- 
titled, unless  there  is  some  clear  agreement  to  the  contrary, 
to  vote  on  an  equality  with  common  shareholders. 


8o  CAPITAL 

Dividend  Rights  of  Preferred  Shares 

^  Unless  otherwise  expressly  provided,  preferred  stock  par- 
ticipates equally  with  the  common  stock  in  all  dividends  after 
both  common  and  preferred  have  received  an  equal  dividend. 
That  is,  if  the  preferred  stock  has  received  its  preferential 
dividend  of,  say,  6%  together  with  any  cumulated  arrearages, 
it  participates  no  further  in  dividends  until  6%  has  been  paid 
upon  the  common  stock  as  well,  but  thereafter  both  classes  of 
stock  stand  upon  exactly  the  same  basis  as  to  any  further 
dividends  declared  during  that  year.  If  such  further  partici- 
pation on  the  part  of  the  preferred  stock  is  not  desired,  it 
must  be  expressly  denied.  Ordinarily  the  charter  contains  a 
provision  prohibiting  such  participation,  in  which  case  the 
preferred  shares  receive  their  fixed  dividends,  but  no  more. 
Yet  there  are  numerous  exceptions  to  this  general  rule.  For 
instance,  the  American  Brake  Shoe  and  Foundry  Com- 
pany pays  7%  on  preferred  shares,  and  follows  that  with 
7%  on  common  shares;  the  preferred  shares  are  then  entitled 
to  all  additional  earnings.  The  Chicago,  Milwaukee  and  St. 
Paul  Railroad  Company's  preferred  has  a  prior  claim  to  7%. 
and,  after  the  common  has  received  7%,  shares  equally  with 
the  common  in  any  further  distribution.  The  Chicago  and 
Northwestern  Railway's  preferred  is  entitled  to  7%,  to  be 
followed  by  7%  on  the  common^  and  then  the  preferred  is 
entitled  to  an  additional  3%  before  the  common  draws  any- 
thing more.  At  present  the  preferred  stock  of  this  company 
is  receiving  8%,  and  the  common  7%. 

AHis-Chalmers  Company  preferred  draws  7%,  then  the 
common  7%,  then  the  preferred  is  entitled  to  1%  extra  but 
has  no  further  claim.  James  Stewart  and  Company  has  out- 
standing $1,500,000  7%  cumulative  second  preferred,  which 
participates  equally  with  the  common  in  further  distributions 
after  the  common  has  received  10%.  Harrison  and  Crossfield, 
Ltd.,  a  large  English  house  dealing  in  foreign  and  colonial 


OWNED   CAPITAL  gl 

produce — tea,  rubber  and  the  like — has  outstanding  a  pre- 
ferred ordinary  issue  of  £300,000  drawing  a  cumulative  div- 
idend of  5%.  After  an  equal  amount  has  been  paid  on  the 
management  shares,  the  balance  of  the  profits  are  divided 
equally  until  the  preferred  ordinary  have  received  a  further 
5%  ;  the  remaining  surplus  is  the  property  of  the  manage- 
ment shares.  The  preferred  ordinary  shares  have  received 
their  full  10%:  dividend  each  year  since  the  formation  of  the 
company.  Aberthaw  and  Bristol  Channel  Portland  Cement 
Company,  an  English  concern,  has  a  preferred  issue  which 
is  entitled  to  10%,  and  which,  after  10%,  has  been  paid 
on  the  common,  receives  two-thirds  of  the  remaining 
profits. 

Redemption  of  Preferred  Shares 

There  are  a  number  of  provisions  concerning  the  redemp- 
tion of  preferred  shares,  that  are  worth  noting.  The  General 
Asphalt  Company  has  outstanding  $14,000,000  5%  cumula- 
tive preferred  which  is  convertible  into  common  at  any  time 
on  even  terms,  in  addition  to  which  the  preferred  shareholder 
will,  in  this  case,  receive  also  $50  of  common  that  is  held  in  a 
trust  fund.  Thus  $100  of  preferred  stock  can  be  converted 
into  $150  of  common  at  any  time.  The  American  Oriental 
Company  has  outstanding  $2,000,000  7%  participating  pre- 
ferred which  is  convertible  into  common,  share  for  share.  As 
to  the  rate  of  redemption,  the  Fisk  Rubber  Company  has  an 
unusual  provision  to  the  effect  that  in  case  of  forced  liquida- 
tion the  preferred  stock  is  entitled  to  par  and  accrued  divi- 
dends, but  in  case  of  voluntary  liquidation  it  is  entitled  to  120% 
of  par  and  accrued  dividends.  A  few  English  companies  base 
the  redemption  of  their  shares  of  preferred  on  the  market 
value.  Thus  Apollinaris  and  Johannis,  Ltd.,  provide  that 
in  the  event  of  voluntary  liquidation  all  preference  stock  shall 
be  entitled  to  a  sum  equal  to  the  average  price  at  which  the 


82  CAPITAL 

stock  has  been  sold  in  two  preceding  years,  but  not  less  than 
par.  R.  and  J.  Dick,  an  English  concern  which  does  an  ex-- 
tensive  business  in  the  United  States  in  boots,  shoes  and  belt- 
ings, provides  that  in  the  event  of  dissolution  the  preferred 
shares  shall  have  a  prior  claim  up  to  their  par  value,  plus  a 
sum  equal  to  the  average  premium  at  which  the  shares  may 
have  been  quoted  at  Glasgow  during  the  three  years  preceding 
dissolution. 

General  Characteristics  of  Preferred  Shares 

From  the  various  examples  that  have  just  been  cited,  the 
reader  may  construct  a  composite  picture  of  preferred  share 
issues.  He  will  find  that  they  range  in  their  fixed  dividend 
rate  from  as  low  as  4%  to  as  high  as  10%,  with  a  marked 
preference  among  industrials  for  7%.  He  will  find  that  a 
great  majority  either  are  irredeemable  or  are  redeemable  at 
the  option  of  the  corporation,  and  that  a  small  number  are 
protected  by  sinking  funds  and  by  other  provisions  which 
make  them,  for  all  practical  purposes,  obligations  of  the  cor- 
poration. 

In  the  United  States  comparatively  few  preference  shares 
are  given  voting  power.  In  England,  and  more  especially  in 
Canada,  the  custom  is  just  the  reverse.  It  is,  however,  becom- 
ing more  and  more  common  in  this  country  to  give  preferred 
shares  some  contingent  voting  power  so  that  they  may  assume 
control,  or  at  any  rate  exercise  some  influence,  in  case  of  de- 
fault of  payment  of  their  regular  dividends.  There  are  many 
preferred  shares  that  have  some  claim  on  dividends  above 
their  fixed  rate ;  these  are  known  as  "participating  preferred" 
shares.  Special  provisions  regarding  convertibility  and  re- 
demption are  found  here  and  there.  In  general,  it  should  be 
noted  that  shares  may  be  preferred  in  a  great  many  different 
respects  and  forms,  and  that  it  is  therefore  necessary  to  study 
each  instance  of  preference  separately. 


OWNED  CAPITAL 


83 


Special  Forms  of  Shares 

There  are  many  peculiar  varieties  of  capital  shares  which 
do  not  come  definitely  within  the  two  main  classes,  common 
and  preferred,  or  which  have  notable  features.  In  Great 
Britain  it  is  a  common  practice  to  compensate  the  organizer 
of  a  corporation  by  giving  him  a  final  claim  on  earnings  which 
is  valid  only  after  all  the  claims  of  those  who  have  furnished 
capital  have  been  fully  met.  The  shares  which  represent  this 
claim  are  variously  known  as  "founders'  "  shares,  "manage- 
ment" shares,  and  "deferred"  shares.  Although  this  practice 
is  frequently  condemned,  it  seems  at  least  as  defensible  as  the 
custom  in  the  United  States  in  accordance  with  which  the 
promoter  of  a  corporation  retains  by  way  of  compensation,  as 
much  as  he  can  of  the  common  stock.  Deferred,  management, 
or  founders*  shares  in  England  are  usually  of  very  small  par 
value — most  commonly,  one  shilling  per  share.  In  case  the 
corporation  succeeds  in  fulfilling  the  expectations  of  its  or- 
ganizer, the  founders'  shares  may  come  to  receive  large  div- 
idends and  to  possess  a  high  market  value  altogether  out  of 
proportion  to  their  nominal  value.  Indeed,  there  are  instances 
in  which  separate  companies  have  been  formed  in  order  to  hold 
the  founders'  shares  and  distribute  interest  in  them  in  a  more 
convenient  manner.  A  slightly  different  plan  was  followed  by 
the  holders  of  the  founders'  shares  in  the  original  Suez  Canal 
Company.  There  were  100  of  these  shares  which  were  of  no 
par  value  but  which  were  entitled  to  10%  of  the  surplus  profits. 
These  100  shares  were  divided  into  100,000  and  were  sold  on 
the  open  market.  The  customary  arrangement  is  that 
founders',  management,  or  deferred  shares  shall  take  one-half 
the  profits  remaining  after  the  ordinary  shares  have  received 
a  given  rate  of  dividend. 

Sometimes  voting  shares  are  subjected  to  peculiar  restric- 
tions for  the  sake  of  forestalling  any  danger  of  losing  control 
or  of  bringing  into  the  management  people  who  are  not  de- 


84 


CAPITAL 


sired.  The  Imperial  Tobacco  Company,  Ltd.,  which  is  a  com- 
bination of  the  chief  British  manufacturers  of  tobacco,  has 
but  three  or  four  hundred  holders  of  its  voting  shares  and 
is  controlled  by  a  much  smaller  number.  In  order  to  maintain 
its  character  as  a  "close"  corporation,  it  has  stipulated  in  the 
articles  of  incorporation  that  no  shareholder  may  dispose  of 
his  shares  except  by  offering  them,  through  the  company,  to 
other  shareholders  at  a  price  to  be  fixed  by  the  shareholders 
from  time  to  time.  An  exception  is  made  with  respect  to  the 
transfer  of  shares  to  members  of  the  immediate  family  of  a 
shareholder.  The  price  fixed  for  transfers  has  always  been 
considerably  less  than  the  probable  market  value.  In  19 12, 
for  instance,  when  3%  dividends  were  being  paid,  the  price 
fixed  was  £2.  In  1913,  when  35%  dividends  were  being 
paid,  the  price  fixed  for  these  transfers  was  increased  only  to 
£2  5s. 

In  the  United  States  small,  close  corporations  sometimes 
attempt  to  accomplish  the  same  result  by  means  of  by-laws 
prohibiting  the  sale  of  stock  to  anyone  not  already  a  stock- 
holder, or  prohibiting  the  sale  of  stock  without  the  consent  of 
the  directors,  or  unless  it  has  first  been  offered  to  the  directors 
at  a  price  not  greater  than  that  at  which  it  is  subsequently  to 
be  offered  or  sold  to  outsiders.  These  provisions,  however, 
are  illegal  and  unen forcible.  Nevertheless  they  are  sometimes 
adopted,  and  printed  on  the  face  of  stock  certificates  to  give 
notice  that  outside  purchasers  are  not  welcome,  and  that  what- 
ever rights  they  may  obtain  they  will  be  able  to  enforce  only 
through  legal  process.  Sometimes  stockholders  agree  among 
themselves  to  withhold  their  stock  from  outsiders.  Such  a 
contract  would  be  legal  as  between  the  stockholders,  but  would 
not  affect  the  rights  of  any  outsider  who  might  without  notice 
and  in  good  faith  purchase  some  of  the  stock.  On  the  whole, 
it  may  be  said  that  restrictions  of  this  nature  have  not  proved 
effective  in  this  country. 


OWNED   CAPITAL 


85 


The  Montana  Power  Company  has  two  classes  of  common 
stock.  About  $27,000,000  is  receiving  2%  dividends,  while 
dividends  on  $22,500,000  are  "deferred"  until  certain  new 
plants  are  completed,  and  are  then  payable  only  gradually  over 
a  series  of  years.  Inasmuch  as  the  New  Jersey  laws,  under 
which  the  company  is  incorporated,  do  not  authorize  the  pay- 
ment of  dividends  on  part  of  an  issue  unless  they  are  paid  on 
the  whole  issue,  this  arrangement  seems  at  first  glance  illegal. 
In  response  to  an  inquiry,  however,  the  treasurer  of  the  com- 
pany advises  that: 

The  stockholders  owning  $22,500,000  of  the  stock  of 
this  Company  have  agreed  that,  as  to  their  stock,  divi- 
dends may  be  deferred  until  a  certain  time,  and  that 
stock  has  been  conveyed  to  certain  trustees,  who  hold  the 
same  for  the  purpose  of  securing  the  provisions  of  the 
agreement  with  regard  to  deferred  dividends.  As  any 
part  of  the  stock  becomes  entitled  to  dividends,  it  will 
be  released  from  the  provisions  of  the  trust  agreement 
and  will  be  distributed  to  those  who  are  entitled  to 
receive  it. 

It  appears,  therefore,  that  this  issue  of  "deferred"  stock — the 
term  was  previously  almost  unknown  in  the  United  States — 
is  made  possible  solely  by  voluntary  agreement  among  certain 
stockholders. 

Another  issue  which  is  unusual  is  the  "assenting"  stock 
of  the  Westinghouse  Electric  and  Manufacturing  Company. 
This  is  an  outgrowth  of  the  reorganization  of  the  company, 
in  1 89 1,  at  which  time  the  common  stockholders  were  asked 
to  surrender  40%  of  their  holdings  and  retain  60%.  This 
60%  was  to  be  called  "assenting"  stock,  and  was  to  receive 
7%  preferential  dividends  before  the  other  common  stock,  no 
part  of  which  was  surrendered.  In  other  words,  the  "assent- 
ing" stock  became  practically  a  second  preferred  and  might 
have  been  so  designated. 


86  CAPITAL 

Certificates  of  Stock 

A  certificate  of  stock  and  the  stock  Itself  are  two  different 
things.  The  certificate  is  in  the  nature  of  a  receipt.  It  cer- 
tifies that  a  given  individual  is  the  owner  of  so  many  shares, 
and  usually  gives  a  brief  digest  of  the  special  conditions,  or 
terms,  if  there  are  any,  which  govern  these  shares.  The  cer- 
tificate may  be  destroyed  or  lost,  but  neither  contingency 
would  in  itself  affect  the  ownership  of  the  shares,  or  even  the 
legal  evidence  of  ownership  which  consists  of  the  company's 
own  register  of  stockholders  and  of  the  amount  of  their  hold- 
ings. The  loss  or  destruction  of  a  certificate  could  ordinarily 
mean,  therefore,  only  so  much  inconvenience. 

There  are  numerous  technical  questions  with  regard  to  the 
handling  of  stock  certificates  and  the  transfer  of  ownership 
of  stock  through  delivery  of  certificates,  which  can  only  be 
touched  upon  here.  In  one  recent  case  a  stockholder  had  left 
his  certificate,  indorsed  in  blank,  with  a  broker  for  safe- 
keeping. The  broker  fraudulently  sold  the  certificate.  It  was 
pointed  out  by  the  courts  that  if  the  purchaser  actually  was 
innocent  and  was  acting  in  good  faith,  he  had  received  a  good 
title,  and  that  the  presumption  would  be  that  he  relied  upon 
the  indorsement  made  by  the  owner,  inasmuch  as  such  indorse- 
ment would  be  prima  facie  evidence  that  the  owner  intended 
to  give  the  broker  the  right  to  sell  the  stock.  If  the  certificate 
had  been  left  without  being  indorsed,  and  no  power  of  at- 
torney had  been  given  the  broker,  so  that  he  would  have  been 
compelled  to  forge  the  name  of  the  owner,  the  purchaser 
would  not  have  secured  a  clear  title. 

A  question  frequently  raised  is,  what  is  to  be  done  when 
a  stock  certificate  is  lost?  The  secretary  or  transfer  agent  of 
the  corporation  should  be  immediately  notified  not  to  transfer 
it  on  the  books  of  the  corporation.  It  is  usually  difficult  to 
procure  another  certificate,  because  the  corporation  must  be 
protected  against  loss  by  the  filing  of  a  bond,  and  this  bond 


OWNED   CAPITAL 


87 


must  be  kept  in  force  so  long  as  there  is  a  possibility  that  the 
old  certificate  may  turn  up.     Every  state  has  its  own  statute 
of  limitations  showing  how  long  an  obhgation  of  this  kind  is 
to  be  regarded  as  legal  and  en  forcible.     The  important  point -v 
that  should  be  kept  in  mind  in  connection  with  all  such  matters 
is,  that  there  is  an  increasing  tendency,  which  nearly  all  deci-v 
sions  show,  to  make  stock  certificates  strictly  negotiable  instru- 
ments, and  as  such  transferable  by  indorsement  without  its 
being  necessary  to  give  further  proof  of  ownership.     It  must  ^ 
be  remembered  that  the  holder  of  record  of  a  lost  certificate 
can  vote  and  receive  dividends  as  before.     The  loss  of  his  • 
certificate  affects  only  his  power  to  transfer  his  stock. 

As  has  been  indicated,  stock  certificates  of  the  larger  cor- 
porations in  the  United  States  are  always  "registered,"  that 
is  to  say,  the  list  of  stockholders  of  a  corporation  is  kept  in  a 
register,  and  transfers  from  one  name  to  another  are  made 
on  presentation  of  the  stock  certificate  properly  indorsed.  In 
England  a  comparatively  small  amount  of  stock  is  "inscribed." 
In  this  case  the  holder  is  given  merely  a  stock  receipt,  which 
has  no  special  value  or  importance.  Whenever  it  is  desired 
to  transfer  stock  holdings  the  owner  must  appear  in  person, 
or  in  the  person  of  some  one  legally  entitled  to  act  as  his 
attorney,  at  the  office  of  the  corporation  and  there  attest 
the  transfer  by  signing  his  name  in  the  transfer  book.  This 
is  too  cumbersome  a  method  to  be  practicable  except  for  small 
or  close  corporations. 

A  third  form  in  which  certificates  may  be  issued  is  the 
"bearer"  form.  In  the  United  States  there  are  few,  if  any, 
bearer  certificates  of  stock.  In  England  they  are  used  for 
preferred,  guaranteed,  and  debenture  stocks  when  the  rates 
of  dividend  or  interest  are  fixed,  and  when  there  is  a  definite 
date  of  redemption.  Inasmuch  as  the  ownership  of  bearer 
securities  is  not  registered,  the  certificate  itself  is  the  sole 
evidence  of  ownership  and  must  therefore  be  guarded  with 


88  CAPITAL 

great  care.  Ordinarily,  coupons  (which  are,  in  effect,  a  series 
of  post-dated  checks,  one  for  each  interest  or  dividend  pay- 
ment) are  attached  and  must  be  cut  off  and  deposited  for 
payment  at  the  proper  time. 

Par  Value  of  Shares 

The  par  value  of  shares  of  stock  may  vary  in  any  amount 
from  as  low  as  one  cent  to  as  high  as  thousands  of  dollars. 
In  some  states  the  minimum  par  value  is  fixed  at  $i,  $5,  or 
$10,  as  the  case  may  be.  Nearly  all  shares  in  the  United 
States  are  $100  or  less,  with  an  overwhelming  majority  fixed 
at  $100.  The  next  most  popular  figure  is  $50,  and  then 
probably  $25,  $15,  and  $10.  In  recent  years  the  tendency 
to  issue  shares  without  par  value  has  grown  stronger  and 
stronger. 

There  is  also  a  tendency,  which  appears  to  be  growing  in 
strength,  to  reduce  the  par  value  of  shares  of  many  cor- 
porations that  are  looking  for  wide  distribution  of  their  stock, 
and  especially  of  those  corporations  that  desire  to  have  their 
own  employees  become  interested  in  the  company  as  stock- 
holders. It  is  said  that  during  a  visit  to  England  in  191 3 
George  J.  Whalen,  president  of  the  United  Cigar  Stores  Com- 
pany, was  much  impressed  by  the  fact  that  most  English 
industrial  and  commercial  shares  have  a  par  value  of  £1  or 
£2.  Under  his  influence  the  par  value  of  the  United  Cigar 
Stores  stock  has  been  changed  from  $100  to  $10,  the  par 
value  of  the  stock  of  the  Corporation  of  RIker-Hegeman  from 
$100  to  $5,  and  the  shares  of  the  United  Profit  Sharing  Cor- 
poration were  brought  out  at  a  par  value  of  $1.  A  number 
of  Important  companies  like  the  National  Transit  Company 
and  the  Eastern  Steamship  Company  have  made  the  par  value 
of  their  shares  $25. 

On  the  other  hand,  there  are  a  number  of  instances  of 
closely  held  shares  which  have  an  exceptionally  high  par  value. 


OWNED   CAPITAL  g^ 

I.alance  and  Grosjean  Alanufacturing  Company,  a  New  York 
corporation,  has  common  stock  of  a  par  value  of  $500.  The 
par  of  the  stock  of  the  Tribune  Association,  the  company 
which  publishes  the  New  York  Tribune,  is  $1,000.  The  par 
value  of  the  stock  of  Tiffany  and  Company  is  also  $1,000. 

Issue  of  Shares — Full-Paid  and  Partly  Paid  Shares 

The  theory  of  the  law  is  that  all  corporate  securities  are 
issued  in  exchange  for  cash,  or  other  value,  equivalent  at 
least  to  the  nominal  value  of  the  shares.  If  shares  are  issued, 
without  proper  consideration,  they  may  be  cancelled  as  invalid. 
An  important  case  in  point  was  decided  in  the  State  of  New 
York  in  19 1 2.  It  appears,  according  to  testimony,  that  at 
the  time  Henry  O.  Havemeyer  was  president  of  the  American 
Sugar  Refining  Company,  he  undertook,  in  behalf  of  his  com- 
pany, to  purchase  shares  of  the  National  Sugar  Refining  Com- 
pany and  otherwise  to  help  finance  that  concern.  In  return 
for  his  services  he  received  $10,000,000  of  the  common  stock 
of  the  National  Sugar  Refining  Company.  When  suit  was 
brought  against  his  estate  several  years  later  for  cancellation 
of  this  issue,  it  was  decided  by  the  courts  that  insufficient  con- 
sideration had  been  received,  and  that  the  whole  issue  should 
be  declared  void. 

Some  governments  will  not  permit  payment  for  stock  to 
be  made  in  anything  except  cash.  The  State  of  New  Jersey 
allows  payment  in  cash  and  property,  excluding  services. 
These  limitations,  however,  are  of  no  great  practical  im- 
portance, for  it  is  a  very  simple  matter  to  arrange  for  an 
exchange  of  checks  which  will  satisfy  the  technical  require- 
ments of  the  law  and  at  the  same  time  accomplish  the  identical 
purpose  that  would  have  been  accomplished  if  property  or 
services  had  been  directly  accepted  in  payment  for  the  stock. 

In  this  country  stock  is  seldom  issued  for  less  than  its- 
par  value,  and  is  seldom  allowed  to  remain  permanently  "partly 


90 


CAPITAL 


paid."  In  England  partly  paid  shares  are  common,  especially 
in  banking  corporations.  In  this  case  the  unpaid  portion  of 
the  shares  remains  as  a  liability  of  the  shareholder  and  is 
therefore  a  source  of  strength  to  the  institution.  In  both 
countries,  with  very  few  exceptions,  shares  that  are  issued  for 
cash,  property,  or  services  valued  at  less  than  the  par  value 
of  the  shares,  carry  with  them  an  obligation  on  the  part  of 
the  holder  to  pay  up  the  difference  at  any  time  that  the  cor- 
poration— or  the  receiver  for  the  corporation  if  it  should  be- 
come insolvent — may  call  upon  him  to  do  so.  This  liability 
does  not,  however,  extend  to  an  innocent  holder  for  value. 

A  bona  fide  purchaser  for  value  and  without  notice 
of  stock  issued  by  a  corporation  as  "paid  up"  cannot  be 
held  Hable  on  such  stock  in  any  way,  either  to  the  cor- 
poration, corporate  creditors,  or  to  other  persons,  even 
though  the  stock  was  not  paid  up  as  represented.  Such  a 
purchaser  has  a  right  to  rely  on  the  representations  of 
the  corporation  that  the  stock  is  paid  up.* 

Partly  paid  stock  may  at  some  later  date  be  made  full-paid 
if  the  corporation  prospers  and  accumulates  a  sufficient  sur- 
plus to  enable  it  to  declare  a  stock  dividend  equivalent  to  the 
unpaid  portion  of  the  shares.  Some  time  ago  one  Utah  cor- 
poration, the  stock  of  which  had  been  only  20%  paid,  found 
itself  in  a  position  to  declare  an  80%  stock  dividend.  There 
was  probably  no  doubt  about  the  legality  and  the  propriety 
of  this  procedure.  The  corporation's  surplus  was  genuine, 
and  it  was  much  better  for  the  shareholders  to  be  relieved  of  I 
their  obligation  than  to  continue  to  carry  so  much  of  a  surplus] 
account. 

Under  certain  conditions  shares  may  be  sold  by  a  corpora- 
tion below  their  par  value  and  still  be  regarded  as  full-paid. 
-The  chief  condition  is  that  the  corporation  shall  be  in  need  of] 


*Cook  on  Corporations,  §50. 


OWNED   CAPITAL  OI 

funds  and  shall  not  be  able,  with  reasonable  effort,  to  dispose 
of  its  shares  at  or  above  their  par  value.  In  the  same  way  an 
insolvent  corporation  may  be  permitted  to  issue  some  of  its 
shares,  in  payment  of  its  debts,  at  a  price  below  the  par  value 
of  the  stock. 

Bonus  Shares 

A  question  which  often  arises  is  that  of  issuing  common 
stock  as  a  bonus  in  connection  with  bonds  or  with  preferred 
stock.    It  is  common  practice,  for  example,  to  sell  the  bonds  of 
industrial  and  public  utility  companies  at  par  with  a   io%, 
20%,  or  some  other  percentage  bonus  of  common  stock.     On 
the  surface  it  appears  that  the  stock  is  being  given  away,  and 
that  the  purchasers  and  subsequent  holders  must  assume  a 
liability  to  pay  its  full  par  value  on  demand.     Ordinarily,  this 
offer  is  made,  not  directly  by  the  corporation,  but  by  a  firm  of 
bankers  or  brokers  which  has  probably  secured  the  common 
stock  according  to  part  of  a  contract  which  includes  compensa- 
tion for  their  own  services;  the  stock  has  thus  been  made 
"full-paid."    Even  when  the  purchase  is  made  direct  from  the  * 
corporation,  however,  it  may  involve  no  liability  on  the  stock ; 
for  technically  the  purchaser  is  supposed  to  pay  the  full  par 
value  of  the  stock  and  to  take  the  bonds  at  a  discount.     In 
most  of  the  states  there  is  no  statutory  or  common  law  which 
prevents  the  sale  of  the  bonds  or  other  obligations  of  a  cor- 
poration at  a  discount.     When  common  stock  is  issued  as  ax 
bonus  with  preferred  stock,  the  case  may  be  different.    Under 
such  circumstances  there  are  technical  points  which  are  va- 
riously interpreted  in  different  jurisdictions.     In  the  State  of' 
Washington,   the   Supreme   Court  has   recently  decided  that' 
persons*  receiving  shares  of  common  stock  as  a  bonus  with, 
preferred  are  liable  for  the  par  value  of  such  stock,  the  accep-^' 
tance  of  the  bonus  stock  carrying  an  implied  promise  to  pay' 
for  it  if  payment  is  called  for. 


92 


CAPITAL 


Watered  Shares — Overcapitalization 

While  it  may  seem  that  the  corporation  laws  almost  with- 
out exception  prohibit  the  issuance  of  full-paid  shares  for  less 
than  the  equivalent  of  their  par  value,  and  that  it  would  be 
impossible,  therefore,  for  a  corporation  to  start  out  with  a 
capitalization  higher  than  the  actual  market  value  of  its 
property,  it  is  well  known  that  in  actual  practice  this  law  is 
frequently  ignored. 

The  capitalization  of  many  corporations  does  not  corre- 
spond, or  even  tend  to  correspond,  closely  to  the  value  of  their 
assets.  How  is  it  possible  to  introduce  this  overcapitaliza- 
tion— or  "water,"  as  it  is  sometimes  called — without  acting 
directly  in  opposition  to  the  law?  The  answer  is  to  be  found 
in  the  process  of  placing  a  valuation  on  the  property  or  ser- 
vices acquired  by  the  corporation.  It  is,  of  course,  impossible 
to  place  an  overvaluation  on  cash  payments  for  stock.  It  is 
difficult  to  place  an  excessive  overvaluation,  even  if  it  should 
be  desired  to  do  so,  on  tangible  property  that  is  accepted  in 
payment  for  stock;  such  property  is  for  the  most  part  of  fairly 
-stable  and  easily  ascertainable  value.  But  in  the  valuation  of  in- 
tangible property — good- will,  patents,  trade-marks,  copyrights, 
organization,  and  the  like — and  in  the  valuation  of  special 
services,  there  is  every  opportunity  to  fix  any  figure  that  may 
be  desired  by  the  organizers  of  the  corporation.  It  is  not 
necessary  to  assume  a  wilful  falsification  of  values  in  every 
instance  in  which  a  corporation  is  later  shown  to  have  been 
overcapitalized.  Organizers  are  likely  to  be  sanguine  men 
who  sincerely  believe,  at  least  for  the  time  being,  that  the 
property  they  are  acquiring  has  a  remarkable  potential  value. 
i»By  means,  therefore,  of  the  simple  device  of  issuing  stock 
for  intangible  property  and  services  at  whatever  valuation  the 
directors  of  a  corporation  agree  upon,  it  is  possible  to  adjust 
the  capitalization  of  the  corporation  to  suit  the  ideas  and  in- 
terests of  the  organizers  of  the  corporation. 


OWNED   CAPITAL  93 

The  promoter  of  a  mining  company,  to  imagine  an  extreme 
case,  thinks  it  possible  to  sell  $1,000,000  par  value  of  stock 
provided  he  can  offer  it  at  a  heavy  discount,  say  10  cents  on 
the  dollar.  His  first  step  after  incorporating  his  company 
is  to  procure  a  piece  of  property  that  may  be  represented  as  a 
prospective  mine.  He  places  a  valuation  of  $1,000,000  on 
this  property  and  sells  it  to  the  corporation — the  directors  of 
which  are  his  own  "dummies" — for  $1,000,000  par  value  in 
stock.  The  promoter  is  then  ready  to  sell  his  stock  to  the 
public  at  any  price  he  may  see  fit  to  put  upon  it.  The  stock 
has  been  made  full-paid  because  it  has  been  issued  for  prop- 
erty which  the  directors  have  declared  to  be  worth  $1,000- 
000.  This  assumed  transaction  would  probably  be  purely 
fraudulent.  The  same  principle,  however,  is  applied  in  or- 
ganizing many  legitimate  corporations. 

For  instance,  at  the  inception  of  the  United  States  Steel 
Corporation,  all  the  preferred  and  common  shares,  as  well  as 
its  5%  gold  bonds,  were  turned  ever  to  a  syndicate  of  bankers 
headed  by  J.  P.  Morgan  and  Company,  in  exchange  for  $25,- 
000,000  in  cash  plus  the  stocks  and  certain  bonds  of  the  seven 
corporations  which  were  at  first  taken  into  the  combination. 
In  view  of  the  fact  that  some  of  the  seven  companies  acquired 
had  a  considerable  amount  of  water  in  their  own  capitaliza- 
tion, and  inasmuch  as  the  $1,300,000,000  stocks  and  bonds 
received  by  the  syndicate  had  a  much  higher  value  than  the 
market  value  of  the  stocks  and  bonds  of  the  subsidiary  com- 
panies, it  is  clear  that  the  Steel  Corporation  started  out  with 
a  large  amount  of  water  in  its  capitalization.  The  estimate 
of  the  market  is  shown  by  the  fact  that  the  common  stock  at 
first  sold  in  the  neighborhood  of  one-third  of  its  par  value.  In 
this  case  the  directors  were  free  to  place  their  own  valuation 
on  the  securities  of  the  subsidiary  corporations  which  they 

K quired,  and  more  especially  on  the  services  rendered  by  the 


94 


CAPITAL 


As  reference  will  be  made  from  time  to  time  in  this  volume 
to  numerous  other  instances  of  overcapitalization,  no  further 

-  examples  need  be  cited  here.  It  may  be  remarked  in  passing, 
however,  that  the  basic  theory  of  the  law  that  capitalization 
should  always  correspond  to  the  actual  market  value  of  the 
assets  of  a  corporation  is,  in  the  judgment  of  many  competent 
thinkers,  both  impractical  and  unsound. 

It  may  be  asked  why  the  courts  do  not  more  frequently 
enforce  a  closer  adherence  to  the  intent  of  the  law.     The 

-answer  has  already  been  partly  indicated.  The  intangible 
assets  and  the  services  which  are  accepted  by  corporations  in 
payment  for  their  stock  are  difficult  to  value,  and  for  this 
reason  it  is  only  in  exceptional  cases  that  bad  faith  on  the 
part  of  corporations  in  making  their  valuations  can  be  con- 
clusively shown.  On  the  numerous  occasions  when  this  ques- 
tion has  been  involved,  the  courts  have  applied  either  one  or 

f  the  other  of  two  rules,  known  respectively  as  the  "true  value" 

2.^  rule  and  the  "good  faith"  rule.  The  true  value  rule,  which 
has  been  applied  in  a  number  of  instances  during  recent  years 
by  the  courts  of  Maine  and  New  Jersey,  is  to  the  effect  that 
in  case  a  wide  discrepancy  between  the  market  value  of  prop- 
erty and  the  par  value  of  shares  for  that  property  can  be 
shown,  it  may  be  assumed  that  the  directors  were  misin- 
formed; hence  the  shares  issued  for  that  property  are  not 
"full-paid,"  and  the  holders  of  these  shares  may  be  sued  for 
the  difference  between  the  real  value  of  the  property  and  the: 
par  value  of  the  shares  they  received.  In  a  New  Jersey  case, 
in  which  the  owner  of  a  patent  had  received  $1,000,000  in 
stock  for  his  contrivance,  after  the  owner's  death  his  estate 
was  found  to  be  liable  to  the  corporation  for  approximately! 
$900,000.  The  other  rule,  which  was  formerly  universal  in 
the  United  States  and  which  is  still  commonly  applied,  in- 
dicates that  directors  may  be  assumed  to  be  acting  in  goodj 
faith  and  with  proper  information  before  them  unless  fraud  | 


OWNED    CAPITAL 


95 


can  be  conclusively  shown.    It  is  well  known  that  it  is  always 
a  difficult  matter  to  produce  legal  evidence  of  fraud. 

Shares  without  Par  Value  f 

In  view  of  what  has  just  been  said  concerning  the  issu- 
ance of  watered  shares,  it  is  clear  that  there  is  no  necessary 
or  even  close  relationship  between  the  par  value  and  the  market 
value  of  the  shares  of  many  corporations.  A  glance  at  the 
daily  list  of  sales  on  any  stock  exchange  will  substantiate  this 
statement.  In  order  to  avoid  all  question  in  regard  to  over-  * 
capitalization  and  undercapitalization  and  concerning  the  value 
of  property  acquired  in  exchange  for  shares,  a  considerable 
number  of  corporations  have  adopted  the  plan  of  issuing  shares 
without  par  value.  The  company  makes  no  claim,  either  ex- 
pressed or  implied,  as  to  the  value  of  the  assets.  Its  balance 
sheet  shows,  instead  of  capital  stock  and  surplus,  simply  the 
value  of  the  equity  which  is  divisible  among  the  shareholders. 
Anyone  interested,  if  he  knows  the  number  of  shares  out- 
standing, may  figure  for  himself  the  book  value  of  each  share. 
This  method  furnishes  probably  the  simplest  and  most  satis- 
factory means  of  handling  the  whole  question  of  capitalization 
and  of  valuation  of  property  and  services.  Among  the  cor- 
porations which  have  adopted  this  system  are  the  following: 
the  Submarine  Boat  Corporation,  which  was  chartered  in  New 
York  in  August,  19 15,  with  800,000  shares  of  no  stated  par 
value;  the  Kennecott  Copper  Company,  which  is  understood 
to  be  a  Guggenheim  enterprise ;  the  Adams  Express  Company ; 
the  Amoskeag  Manufacturing  Company;  and  Montgomery, 
Ward  and  Company. 

Methods  of  Voting 

In  the  United  States  the  well-established  custom  is  to 
allow,  for  every  share  of  voting  stock,  one  vote  in  the  election 
of  directors  and  in  the  decision  of  other  questions  that  come 


ge  CAPITAL 

-before  shareholders.  As  a  result,  the  larger  shareholders  ex- 
ercise almost  complete  control.  Not  only  do  they  possess  the 
greater  number  of  shares,  but  they  have  a  large  enough  finan- 
cial interest  at  stake  to  make  it  worth  while  for  them  to  take 
an  active  part  in'  the  affairs  of  the  corporation.  The  small 
holder,  on  the  other  hand,  feels  that  he  can  exercise  no  real 
influence,  and  that  it  is  not  worth  his  while  to  attend  meetings 
or  even  to  send  in  a  proxy,  or  written  authorization,  to  some 
officer  or  other  person  present  to  act  for  him. 

In  the  United  States  Steel  Corporation  those  shareholders 
who  own  i,ooo  or  more  shares  each,  have  in  the  aggregate  a 
larger  number  of  votes  than  the  vast  majority  of  smaller 
stockholders.  It  is  safe  to  assume,  therefore,  that  even  in  so 
large  a  corporation  these  comparatively  few  men  are  the  ones 
who  are  keenly  and  directly  interested  as  shareholders,  and 
take  the  trouble  to  try  to  elect  directors  who  will  represent  their 
views.  It  is  for  this  reason,  primarily,  that  in  the  United 
States  complete  control  of  a  corporation  may  be  obtained  by 
one  man,  or  by  a  group  of  men,  who  own  perhaps  only  a  small 
percentage  of  its  outstanding  stock.  This  has  been  notably 
true  of  some  of  the  large  railroad  systems.  It  is  stated  that 
at  the  time  when  George  J.  Gould  was  in  undisputed  control 
of  the  Wabash  and  the  Missouri  Pacific  railroads,  he  and  his 
family  never  had  more  than  12%  of  the  outstanding  stock. 
It  is  said  that  the  control  of  a  bank  or  a  trust  company  may, 
under  ordinary  conditions  of  stock  ownership,  be  retained  by 
the  holders  of  30%  of  the  outstanding  stock. 

In  English  practice  a  different  principle  as  to  voting  is 
customarily,  though  not  universally,  followed.  In  order  that 
complete  domination  by  the  large  shareholders  may  be  pre- 
vented, a  limitation  is  placed  on  the  number  of  votes  that  ma] 
be  cast  by  any  one  shareholder ;  or,  instead,  a  regressive  scale 
is  so  arranged  that  the  number  of  votes  does  not  increase  h 
proportion  to  the  number  of  shares.    This  practice  dates  bad 


OWNED   CAPITAL 


97 


several  generations.  The  "Companies  Clauses  Consolidation 
Act"  of  1845  provides  that  whenever  no  scale  of  voting  is 
prescribed  in  the  by-laws,  every  shareholder  shall  have  one 
vote  for  every  share  he  holds,  up  to  10;  an  additional  vote 
for  every  5  shares,  up  to  100;  and  an  additional  vote  for 
every  10  shares  beyond  100.  The  Sheffield  United  Gas  Light 
Company  allows  a  shareholder  not  more  than  30  votes;  the 
London  Gas  Light  and  Coke  Company,  not  more  than  10 
votes ;  the  Bristol  United  Gas  Light  Company,  not  more  than 
5  votes;  the  Black  Pool  Tower  Company,  not  more  than  20 
votes.  It  is  said  that  attempts  to  evade  this  restriction  are 
uncommon  and  that  attempts  to  purchase  control  of  established 
corporations  in  order  to  bring  about  combinations,  and  for 
other  purposes,  are  not  nearly  so  frequent  in  England  as  in 
this  country.  There  are  obvious  advantages  in  this  practice 
that  are  well  worth  considering,  particularly  those  that  have  to 
do  with  the  enlistment  of  the  active  interest  of  the  smaller 
shareholders  and  the  interposition  of  obstacles  to  exploitation. 
It  is  quite  possible  that  the  practice  might  be  adopted  to  ad- 
vantage, especially  by  local  corporations  which  may  have  meet- 
ings of  shareholders  from  time  to  time,  and  in  which  the  per- 
sonal influence  of  these  shareholders  is  of  real  importance  and 
value. 

Cumulath^eJ^iiting^ 

The  obvious  injustice  and  danger  of  permitting  the  holders 
of  a  majority  of  the  voting  stock — or  rather,  in  many  cases, 
the  officials  and  others  who  can  most  easily  procure  for  them- 
selves the  right  to  represent  the  majority  of  voting  stock — 
to  elect  all  the  directors,  and  thereby  to  take  full  and  unre- 
stricted control  into  their  own  hands,  has  led  to  the  growing 
popularity  and  the  very  general  adoption  of  another  method 
of  voting:  namely,  the  cumulative  method. 

Cumulative  voting  may  be  defined  as  a  method  whereby 


98 


CAPITAL 


■each  shareholder  may  cast  as  many  votes  as  he  holds  shares  of 
stock,  multiplied  by  the  number  of  directors  to  be  elected.  A 
shareholder  may  cast  all  of  his  votes  for  one,  or  two,  or  more 
candidates,  or  he  may  distribute  them  in  any  other  proportion 
he  sees  fit.  Thus  the  minority  shareholders  may  so  combine 
and  concentrate  their  votes  as  to  make  certain  of  electing  one 
or  more  representatives  to  the  board  of  directors. 

To  illustrate,  let  us  assume  that  a  corporation  has  i,ooo 
shares  outstanding,  600  of  which  are  in  the  hands  of  a  major- 
ity party,  and  that  five  directors  are  to  be  elected.  Under 
the  usual  system  of  allowing  one  vote  to  each  share  and  vot- 
ing for  each  director  separately,  the  majority  shareholders 
may  pick  out  the  full  board  of  directors  without  any  reference 
whatsoever  to  the  wishes  or  interests  of  the  minority.  Under 
the  cumulative  system  of  voting,  the  majority  party  would 
have  5  times  600,  or  3,000  votes  altogether,  at  their  disposal, 
and  the  minority  party  would  have  only  2,000  votes.  If  the 
majority  party  should  attempt  to  elect  all  five  directors,  they 
could  give  only  600  votes  to  each  one  of  the  five ;  the  minority 
party  could  meet  this  move  by  concentrating  their  2,000  votes 
on  three  directors,  giving  each  one  666  votes,  and  thus  elect 
a  majority  of  the  board.  In  order  to  make  themselves  secure^ 
the  majority  party,  presumably,  would  concentrate  on  three 
directors,  each  one  of  whom  would  get  1,000  votes;  and  th( 
minority  party  would  concentrate  on  two  directors,  each  one 
of  whom  would  receive  1,000  votes.  Each  party  would  thuj 
secure  representation  on  the  board  in  exact  proportion  to  itj 
shareholdings  in  the  corporation.  In  practice  the  situatioi 
would  never  be  quite  so  simple,  but  the  result  of  giving  rej 
resentation  in  approximate  proportion- to  shareholdings  woul< 
be  obtained. 

=■  There  appears  to  be  no  question  but  that  cumulative  voting 
tends  to  prevent  injustice  and  exploitation,  and  that  it  leads 
to  a  more  active  interest  on  the  part  of  the  smaller  share 


OWNED   CAPITAL  gg 

holders,  who  have  under  this  method  a  better  chance  to  secure 
representation.  Among  the  large  companies  which  have 
adopted  cum.ulative  voting  are  the  Anaconda  Copper  Mining 
Company  and  the  Ingersoll-Rand  Company.  Cumulative  vot- 
ing is  permitted  by  the  laws  of  practically  all  the  states,  and 
is  specifically  required  in  some,  including  Pennsylvania  and 
Illinois. 

Stockholders*  Meetings 

The  larger  corporations  in  the  United  States  make  it  their 
custom  to  send  out  notices  of  annual  meetings  to  all  stock- 
holders, and  to  forward  with  these  notices  a  printed  proxy, 
which  authorizes  the  secretary  or  some  other  officer  of  the 
corporation  to  represent  the  shareholder  at  the  annual  meet- 
ing. Most  of  the  corporations  supply  stamped  envelopes  and, 
if  they  do  not  hear  from  the  shareholder,  forward  a  second 
request  for  his  proxy.  All  that  the  shareholder  is  asked  to  do 
is  to  sign  his  name,  enclose  the  proxy  in  the  envelope  and 
mail  it.  Nevertheless  the  interest  on  the  part  of  the  average 
shareholder  is  so  slight  that  only  a  small  proportion  of  these 
proxies,  it  is  stated,  are  ordinarily  returned.  It  is  easy  enough 
to  return  the  proxy,  but  it  is  just  a  trifle  easier  to  drop  it  into 
the  waste  basket.  Probably  the  average  shareholder  sees  no 
reason  why  he  should  take  action  one  way  or  the  other.  He 
does  not  know  whether  the  corporation  is  being  well-managed 
or  whether  the  officers  and  directors  deserve  his  support  or 
not.,  Except  in  very  unusual  cases,  when  there  is  an  opposi- 
tion and  when  a  campaign  to  get  his  support  is  carried  on, 
he  knows  that  his  vote  will  have  not  the  slightest  influence 
either  for  or  against  any  man  or  measure. 

Usually  the  secretary  and  one  or  two  other  officials  of  the 
corporation  take  the  proxies  to  the  annual  meeting,  go  through 
all  the  formalities  of  electing  a  chairman  and  a  secretary,  pre- 
senting reports  and  casting  votes,  and  carry  out  whatever 


lOO  CAPITAL 

programme  has  been  agreed  upon  by  the  officers  of  the  cor- 
poration. Every  year,  for  instance,  an  officer  of  the  Union 
Pacific  Railroad  Company  takes  a  satchel  full  of  proxies, 
makes  the  trip  from  New  York  to  Salt  Lake  City  (the  Union 
Pacific  Railroad  Company  being  incorporated  in  Utah)  and 
holds  the  annual  meeting.  Even  when  action  out  of  the  or- 
dinary is  proposed,  very  few  shareholders  ever  take  the  trouble 
to  attend  these  meetings. 

At  the  annual  meeting  of  the  Northern  Pacific  in  19 14, 
authority  was  asked  for  a  new  issue  of  $750,000,000  in  bonds. 
Some  of  the  shareholders  objected  to  the  looseness  of  the 
authority  asked,  but  the  plan  was  carried  through  without 
effective  opposition  by  voting  the  proxies  previously  collected 
by  the  officers.  An  amusing  account  of  this  meeting  appeared 
in  the  New  York  Annalist  of  June  15,  1914,  from  which  the 
following  paragraphs  are  quoted: 

Eighteen  shareholders,  one  for  every  one  thousand 
stockholders,  were  on  hand  to  see  that  justice  was  done  to 
their  interests.  Four  of  these  were  directors,  one  was 
Chairman  of  the  Board,  another  a  former  Vice-Presi- 
dent; ....  but  the  strength  of  the  meeting  was  not 
in  the  number  present.  When  the  Secretary  took  his 
place,  he  brought  with  him  proxies  for  1,387,202  shares 
of  stock — ^nearly  56%  of  the  total  outstanding.  The  stock- 
holders might  have  talked  their  heads  off,  and  voted  as 
a  unit  against  the  bond  issue,  and  still  it  would  have 
gone  through  when  the  Secretary  put  down  1,387,202 
shares  in  its  favor. 

Colonel  Clough  (the  Chairman  of  the  Board)  sat  in 
a  high-backed  chair  at  the  head  of  a  long  table,  looking 

an   embodiment  of  the   spirit  of  impartiality He 

had  a  courteous  manner  for  each  speaker,  and  in  the  pile 
of  proxies  he  had  a  steam  roller  to  run  over  objections 
when  it  came  to  a  vote. 

After  the  reading  of  the  resolution.  Christian  F.  Leng 
arose  to  call  attention  to  a  small  omission  in  the  resolu- 


OWNED  CAPITAi:  /.  ^     ;  v; :' ^^  ;j  \%i^^ 

tion.  Not  belligerently,  but  as  one  seeking  to  correct 
an  oversight,  he  asked  the  Chair  to  state  the  amount  of 
the  proposed  mortgage.  He  characterized  the  resolution 
as  somewhat  vague  on  that,  to  him,  important  point. 

The  Chair  was  sorry  the  gentleman  did  not  under- 
stand corporation  matters  better.  The  amount  was  to  be 
left  to  the  wisdom  of  a  Board  of  Directors  chosen  by  the 
stockholders  to  safeguard  their  interests.  They  would 
study  the  matter  from  every  angle,  lunch  over  it,  and 
sleep  on  it,  and  in  the  course  of  time  arrive  at  the  total. 

It  seemed  that  Mr.  Leng  was  inclined  to  be  stubborn. 
He  said  the  Chair  evidently  had  failed  to  understand  his 
question,  which  had  nothing  to  do  with  the  province  and 
wisdom  of  Directors,  but  concerned  the  amount  of  the 
proposed  mortgage.  As  the  owners  of  the  corporation, 
he  thought  the  shareholders  entitled  to  know  from  their 
agents  the  amount  to  which  they  proposed  to  bond  the 
property.  *Ts  it  not  a  reasonable  inquiry  to  ask  how 
much  you  propose  to  make  this  mortgage  ?"  he  concluded. 

The  Chair  again  set  about  the  enlightenment  of  the 
Philistine.  Patiently  he  explained  that  were  the  stock- 
holders to  determine  the  amount  of  the  mortgage  they 
might  be  kept  in  session  for  several  days.  That  was  a 
task  for  the  Directors,  a  labor  which  the  shareholders 
should  be  glad  to  escape.  The  Directors  were  in  office 
solely  to  look  after  the  interests  of  the  stockholders. 
They  would  canvass  the  situation,  look  at  it  by  and  large, 
dig  into  figures,  and  attempt  a  forecast  of  the  future. 
The  Chair  was  a  master  of  circumlocution,  and  always 
patient. 

Arose  Mr.  Leng  again,  to  say  that  when  he  put  a 
mortgage  on  his  property  he  did  not  give  a  lawyer  carte 
blanche  to  make  it  as  large  as  he  could.  He  suspected 
that  the  management  had  already  decided  on  a  figure; 
what  he  wanted  to  learn  was  the  figure.  To  which  the 
Chair  replied  that  the  Directors  could  be  trusted  to  do 
what  was  right  in  the  matter. 


The  meeting  having  lasted  as  long  as  conventional 
shareholders'    gatherings    should    continue,    the    steam 


I02      r^  ^^^^^^^^     ^    -   ^    '     CAPITAL 

roller  was  started  gently.  A  vote  on  the  original  resolu- 
tion was  called  for.  On  the  proposition  to  authorize  the 
Directors  to  proceed  with  their  plan,  the  Secretary  an- 
nounced: "Against,  400  shares;  in  favor  of,  1,387,700." 
The  meeting  was  adjourned. 

Voting  Trust 

The  "voting  trust"  has  been  growing  in  favor  during 
recent  years.  It  has  already  been  mentioned  that  at  one  time, 
a  generation  or  more  ago,  the  favorite  form  of  combination 
among  competing  concerns  was  a  body  of  trustees  to  whom 
controlling  shares  in  the  competing  corporations  were  turned 
over — an  arrangement  found  to  be  in  restraint  of  trade  and 
"therefore  illegal.  The  plan  herein  referred  to  is  different,^ 
in  that  it  is  confined  to  one  company  and  its  sole  purpose  is^ 
to  secure  continuity  of  management  and  policy  within  that 
company. 

The  laws  of  most  states  which  authorize  the  formation  of 
a  voting  trust  require  that  it  shall  be  open  to  all  shareholders 
who  wish  to  take  part  in  it.  Without  this  provision  it  might 
become  a  dangerous  device  for  concentrating  control.  In 
fact,  even  with  this  restriction  there  is  reason  to  think  that 
the  voting  trust  has  sometimes  been  used  rather  for  the  benefit 
of  the  trustees  than  for  the  benefit  of  the  corporation. 

The  chief  use — and  a  legitimate  use — of  the  voting  trust, 
however,  is  to  protect  the  shareholders  and  others  who  take 
part  in  a  reorganization.  Ordinarily,  as  we  shall  see  later  on, 
a  reorganization  is  carried  through  by  a  banking  syndicate, 
headed  by  some  powerful  banking  firm.  Naturally  the  firm, 
in  order  to  protect  its  own  reputation  and  the  people  to  whoi 
it  has  sold  the  securities  of  the  reorganized  company,  wishes! 
to  make  sure  that  there  will  be  sound  management  over  a] 
period  of  years.  Yet  it  is  not  in  control  and  perhaps  holds] 
very  little  of  the  company's  stock.  In  order  to  meet  this  situa- 
tion, it  IS  frequently  required  that  a  majority  of  the  voting 


OWNED   CAPITAL  IO3 

stock  be  lodged  with  trustees  under  a  voting  trust  agreement. 
Stuart  Daggett  states  that  out  of  seven  railroad  reorganiza- 
tions, during  the  period  1893- 1898,  five  included  voting  trusts 
and  one  a  proxy  committee  in  the  reorganization  plans. 

A  similar  use  of  the  same  plan  is  the  establishment  of  a 
voting  trust  representing  the  preferred  shareholders  when 
there  has  been  default  in  payment  of  the  preferred  dividends. 
Under  the  laws  of  New  Jersey,  a  voting  trust  cannot  continue 
for  longer  than  five  years,  and  other  states  have  imposed 
similar  limitations.  Ordinarily,  the  trustees  have  an  option 
to  terminate  the  arrangement  at  their  discretion.  When  the 
Northern  Pacific  voting  trust  was  dissolved  in  1901,  the  trus- 
tees explained  the  dissolution:  "by  reason  of  the  evidence  of 
financial  strength,  conservative  management,  skilful  and  prof- 
itable operation,  superior  physical  condition  of  the  property 
and  reasonable  prospect  of  continued  prosperity."* 

Still  another  use  of  the  voting  trust  is  to  prevent  the  con- 
trol from  passing  into  the  hands  of  interests  that  are  not 
regarded  favorably  by  the  management  of  the  corporation. 
When  the  American  Glucose  Company  was  formed,  in  1894, 
the  vice-president  of  the  company  controlled  a  clear  majority 
of  the  stock,  but  it  was  agreed,  nevertheless,  that  the  active 
management  should  be  in  the  hands  of  the  president.  An 
agreement  was  therefore  signed  "to  place  in  the  hands  of 
trustees,  to  be  named  by  the  President,  2,544  shares  of  said 
preferred  stock,  upon  the  trust  that  in  the  election  of  the 
directors  and  officers  of  said  company,  and  upon  other  matters 
arising  at  stockholders*  meetings,  said  trustees  shall  vote 
thereon  as  requested  by  said  President."  The  addition  of  the 
trustees'  stock  to  the  president's  own  holdings  gave  him  control 
of  the  company  and  enabled  him  to  elect  four  out  of  the  seven 
active  members  of  the  board. 

Among  the  various  important  corporations  in  which  there 

*Stuart  Daggett's  "Railroad  Reorganizations,"  p.  310. 


I04 


CAPITAL 


are  now  voting  trusts,  may  be  mentioned  the  Buffalo  Electric 
Vehicle  Company ;  William  Cramp  and  Son,  Ship  and  Engine 
Building  Company;  General  Motors  Company;  Intercontinen- 
tal Rubber  Company;  International  Mercantile  Marine  Com- 
pany; Lehigh  Coal  and  Navigation  Company;  J.  I.  Case 
Threshing  Machine  Company;  Loose- Wiles  Biscuit  Company; 
Hale  and  Kilburn  Company;  and  Allis-Chalmers  Manufactur- 
ing Company. 

Among  smaller  corporations  the  voting  trust  is  somewhat 
unusual.  In  many  cases  it  might  be  found  a  legitimate  and 
helpful  means  of  securing  agreement  and  continuity  of 
policy. 


CHAPTER    VI 

BORROWED  CAPITAL— SHORT-TERM 

Advantages  of  Borrowing 

'The  habit  of  borrowing,"  says  Hartley  Withers,  "is  a 
modern  invention."  There  was  formerly  a  custom  among  all 
well-ordered  governments  and  business  enterprises,  of  amass- 
ing treasure  for  use  in  emergencies ;  without  hoarded  treasure 
even  the  largest  owner  of  property  would  have  been  help- 
less. Today  the  wisest  financial  policy  is  to  pile  up  not" 
treasure,  but  credit.  To  be  sure,  sound  credit  may  require  the 
possession  of  a  certain  proportion  of  gold  and  securities;  but 
this  treasure  no  longer  exists  for  its  own  sake  so  much  as  for 
a  support  and  guarantee  to  credit. 

More  and  more  as  credit  facilities  increase  and  credit 
machinery  works  more  smoothly,  business  enterprises  are 
financed  with  borrowed  capital.  The  great  advantages  of- 
borrowing  are  its  cheapness  and  its  ease.  It  is  cheaper  to- 
borrow  than  to  secure  a  co-owner  or  a  group  of  co-owners  for 
a  business,  because  of  the  greater  security  that  is  offered  to 
the  lender.  To  put  the  same  thought  in  terms  of  corporate 
financing,  first-class  bonds  may  be  sold  on  a  4,  5,  or  6%  basis, 
whereas  preferred  shares  sell  on  a  6,  7,  or  8%  basis,  and 
common  shares  on  a  still  higher  basis.  Hence,  the  larger  the 
proportion  of  capital  which  the  individual  or  corporation  can 
borrow,  the  larger  is  the  yield  on  the  owned  capital. 

Take  a  very  simple  illustration.  Suppose  a  corporation 
with  $100,000  capital  is  regularly  earning  10%,  or  $10,000, 
a  year;  let  us  say  that  $20,000  of  the  capital  is  borrowed  at 
5%,  making  the  interest  payment  $1,000.  Then  the  $80,000 
of  owned  capital  will  have  left  an  income  of  $9,000,  or  a 

105 


I06  CAPITAL 

little  over  ii%.  Let  us  now  make  the  assumption  that  the 
business  is  of  such  a  character  that  $80,000  can  be  borrowed 
at  5%,  making  the  annual  interest  payment  $4,000.  In  that 
case  the  $20,000  of  owned  capital  will  have  left  an  income 
of  $6,000,  or  30%. 

We  have  here  an  explanation  of  the  profit-making  possibili- 
ties— when  properly  financed — of  enterprises  which  yield  only 
a  small  average  return  on  the  invested  capital.  Most  public 
utility  companies,  for  instance,  secure  only  a  moderate  yield 
on  their  actual  investment,  but  these  companies  hold  properties 
which  can  be  mortgaged  up  to  a  high  percentage  of  their 
value.  Hence,  at  least  one-half  the  capital  is  borrowed  and 
the  owned  capital  may  obtain  very  good  dividends.  Accord- 
ing to  the  Electrical  Railway  Review,  the  issued  stock  of  all 
the  electrical  railways  in  the  United  States  for  19 12,  had  a 
par  value  of  $2,945,000,000,  and  for  191 3,  $2,808,000,000,  a 
decrease  of  $137,000,000.  The  bonded  indebtedness  of  these 
companies  for  19 12  was  $2,641,000,000,  and  for  19 13,  $2,- 
814,000,000.  We  see  here  not  only  a  large  proportion  of 
borrowed  capital,  but  its  rapid  increase  from  year  to  year, 
with  a  corresponding  decrease  in  owned  capital.  The  same 
thing  is  true  of  real  estate  operations.  An  extreme  case  is 
that  of  a  New  York  corporation  known  as  the  "Forty-two 
Broadway  Company,"  which  has  a  capital  stock  of  $600  and 
a  bonded  indebtedness  of  nearly  $5,000,000. 

As  to  the  ease  of  borrowing,  it  is  perhaps  suf^cient  to  call 
attention  to  the  immense  quantities  of  bonds  and  notes  which 
are  continually  being  issued  and  sold.  Modern  efHciency  and 
productivity  are  piling  up  wealth  at  a  faster  rate  than  ever 
before.  And  the  security  of  property — except  as  it  may  be 
disturbed  by  tremendous  international  conflicts — is  increasing. 
Now  the  first  thought  of  a  man  who  has  only  a  little  money 
is  to  increase  that  little,  and  he  is  willing  to  take  chances  in 
so  doing.     For  that  reason,  it  is  among  poor  people,  and 


BORROWED   CAPITAL— SHORT-TERM 


107 


especially  poor  people  of  the  professional  classes,  that  the 
swindling  promoter  finds  his  easiest  victims.  But  a  man  who 
has  a  comfortable  amount  of  property  is  looking  for  safety 
rather  than  for  increase.  Hence,  as  the  average  wealth  of  a.] 
country  increases,  not  only  is  more  and  more  capital  released' 
for  investment,  but  a  larger  proportion  of  that  capital  is  look- 
ing first  of  all  for  safe  investment.  In  other  words,  its  owner 
prefers  to  lend  it  rather  than  to  take  greater  chances  as  a 
proprietor  or  part  proprietor. 

Another  factor  working  in  the  same  direction,  is  the  piling - 
up  of  enormous  funds  held  in  trust;  estates  that  are  being 
directed  by  trustees;  the  funds  of  life  insurance  companies; 
the  funds  of  savings  banks  and  the  like.  All  these  trust  funds 
are  available  only  for  lending  on  excellent  security.  For  these 
reasons  a  man  or  a  corporation  who  can  put  enough  owned 
capital  into  a  substantial  enterprise  to  furnish  a  reasonable 
margin  of  safety,  will  generally  find  it  a  comparatively  simple 
and  easy  task  to  borrow  the  remainder  of  the  needed  capital. 

What  has  been  said  applies  more  especially  to  long-term 
or  "funded"  borrowing,  but  much  the  same  statements  hold 
true  on  short-term  borrowing.  "Through  all  business  activi- 
ties," points  out  the  New  York  Annalist,  "there  is  more  capital 
needed  today  than  used  to  be  needed,  but  it  is  wrong  to  take 
it  for  granted  that  an  individual  needs  to  have  more  money 
to  go  into  business."* 

The  explanation  for  this  apparent  paradox  is  to  be  found  " 
in  the  free  use  of  credit  which  is  a  striking  characteristic  of 
all  present-day  business  enterprises.  Manufacturers,  whole- 
salers, and  bankers  are  always  ready  to  extend  credit  freely 
to  young  men  of  ability  and  character.  The  silk  industry  is 
notable  for  the  amount  of  business  that  can  be  done  on  a  very 
slim  margin  of  capital  Raw  silk  is  sold  to  manufacturers  on 
a  credit  basis  that  resembles  "memorandum  credit"  among 


*New  York  Annalist,  April  17,  1914. 


io8  CAPITAL 

jewelers.  Many  factories  are  rented  entire.  It  is  said  that 
in  Philadelphia  the  extensive  cotton  industry  is  in  large 
measure  carried  on  in  the  same  way.  Lofts  with  power  and 
machinery  are  rented ;  materials  are  obtained  on  a  credit  basis. 
The  United  Shoe  Machinery  Company  has  for  many  years 
made  a  practice  of  furnishing  its  machines  only  on  lease;  it 
does  not  sell  them.  In  this  industry,  therefore,  a  man  with 
large  capital  has  no  great  advantage,  so  far  as  obtaining  effi- 
cient machinery  is  concerned,  over  a  man  with  small  capital. 

Proportions  of  Borrowed  Capital 

In  England  the  distinction  between  preference  shares  and 
"debenture"  shares  or  other  forms  of  obligation,  is  so  hazy 
that  owned  capital  almost  imperceptibly  merges  into  borrowed 
capital.  Partly  for  this  reason,  the  proportion  of  borrowed 
capital  often  appears  somewhat  smaller  than  in  this  country. 
For  example,  in  water,  railway,  tramway,  gas,  and  other 
public  utility  companies,  the  amount  of  loaned  capital  is  usually 
limited  to  one-third  of  the  total  capital.  The  Board  of  Trade 
in  railway  returns  for  1910  showed  percentages  of  the  various 
classes  of  railroad  securities  as  follows  :* 

Ordinary  stock 37-3% 

Preference  and  guaranteed  stock 35-8% 

Loan  and  debenture  stock 26.9% 

It  will  be  noted  that  much  of  the  preference  and  guaranteed 
stock  would  normally  be  considered  as  borrowed  capital  in 
this  country,  so  that  actual  practice  in  the  above  classes  of 
undertakings  does  not  differ  much  from  the  practice  in  the 
United  States. 

The  first  schedule  of  the  English  Companies  Consolidation 
Act  of  1908,  provides  that  the  indebtedness  of  a  company  shall 

*Robert  H.  Whitten's  report  on  "Regulation  of  Public  Service  Companies  in 
Great  Britain,"  issued  by  the  Public  Service  Commission,  1st  District,  State  of  New 
York,  1914,  pp.  26  /f. 


BORROWED   CAPITAL— SHORT-TERM  109 

not  at  any  time  exceed  the  amount  of  its  capital  without  the 
sanction  of  the  shareholders  in  general  meeting. 

Against  the  two  great  advantages  of  using  borrowed  capi-- 
tal — cheapness  and  ease  in  procuring  the  funds — there  must 
be  offset  the  obvious  disadvantage,  that  the  risk  to  the  owners 
of  the  share  capital  is  thereby  increased.  The  shareholders 
have,  of  course,  only  an  equity  in  the  property  and  income  of 
the  corporation  which  is  first  subject  to  all  prior  claims  of  the 
holders  of  the  obligations.  This  may  not  involve  a  serious 
risk  in  the  case  of  corporations  that  have  stable  earnings,  but 
when  earnings  fluctuate  widely  from  year  to  year,  even  though 
the  average  return  on  the  invested  capital  may  be  high,  the 
position  of  the  shareholders  with  a  large  indebtedness  ahead 
of  them  may  become  very  uncomfortable.  It  is  for  this  reason 
that  the  tendency  has  been  strong  in  recent  years  for  indus- 
trial corporations  to  shun  even  small  bond  issues  and  to  raise 
their  capital  only  through  common  and  preferred  shares. 
Sometimes  this  cautious  policy  may  be  carried  to  what  appears 
to  be  an  extreme.  Two  large  and  powerful  industrial  corpora- 
tions, for  instance,  the  Pullman  Company  and  the  Singer  Sew- 
ing Machine  Company,  have  no  securities  outstanding  except 
common  stock.  Two  somewhat  smaller  corporations  which 
have  cleared  away  all  their  obligations,  including  even  short- 
time  notes  and  accounts,  are  the  Plume  and  Atwood  Manu- 
facturing Company,  in  Connecticut,  and  the  United  Shoe 
Machinery  Company. 
&  The  unsoundness  of  too  heavy  borrowing  cannot  be  better 
shown  than  by  the  combined  figures  on  the  capitalization  of 
thirteen  large  railway  systems  in  the  United  States  which 
were  in  receivers*  hands  in  the  summer  of  19 14.  The  funded 
debt  of  these  thirteen  railways  was  about  70%,  and  the  stock 
sues  only  about  30%  of  their  total  capitalization. 
To  lay  down  any  exact  rules  as  to  the  proper  proportion 
borrowed  capital,  would  clearly  be  out  of  the  question.    We 


no  CAPITAL 

-are  forced  to  fall  back  on  the  general  statement  that  capital 
should  not  be  borrowed  unless  there  is  a  practical  certainty 
that  both  interest  payments  and  payments  on  principal  can  be 
met  as  they  fall  due.  This  involves  the  further  rule  that  the 
annual  fixed  payments  of  a  corporation  should  be  only  a 
reasonable  proportion,  not  of  the  average  earnings,  but  of  the  I 
lowest  earnings.  The  fact  that  a  corporation  has  made  a  dis- 
tribution or  invested  big  profits  in  one  year,  is  small  comfort 
if  it  finds  itself  in  the  following  year  unable  to  meet  its  ob- 
ligations. 

As  to  payments  on  account  of  principal,  it  has  long  been 
regarded  as  almost  axiomatic  that  companies  doing  a  stable 
business,  such  as  railways  and  public  utilities,  need  make  no 
provision  for  paying  off  and  retiring  their  funded  debts. 
These  companies,  it  has  sometimes  been  said,  will  never  cease 
to  borrow;  therefore,  when  one  obligation  matures,  the  proper 
plan  is  to  refund  it  by  issuing  another  obligation  in  its  place. 
However,  this  principle  is  no  longer  universally  accepted.  In 
fact,  at  the  191 5  meeting  of  the  Investment  Bankers'  Associa- 
tion, the  Committee  on  Railroad  Bonds  and  Equipment  Trusts 
recommended  among  other  things  that  railroad  mortgages 
should  contain  provisions  for  sinking  funds.  Even  railroad 
corporations,  if  this  recommendation  were  generally  adopted, 
would  be  taking  steps  to  pay  off  in  cash  each  obligation  which 
they  incurred. 

Forms  of  Borrowing 

All  borrowing  is  of  two  general  classes,  "short-term"  and 
"long-term."  This  is  by  no  means  purely  a  verbal  difference, 
for  there  are  clear  market  distinctions  between  the  principles 
that  apply  in  these  two  classes.  Just  where  we  should  draw 
the  line  between  the  two  is  a  difficult  question  to  answer ;  it  is 
largely  a  matter  of  usage.  In  Wall  Street,  "short-term' 
usually  refers  to  obligations  having  not  more  than  five  years 


BORROWED   CAPITAL— SHORT-TERM  HI 

to  run;  "long-term"  usually  refers  to  obligations  having,  say, 
twenty  years  or  more  to  run  from  date  of  issue.  Obligations 
running  in  intermediate  periods  might  be  put  in  either  one  or 
the  other  of  the  two  groups.  The  question  is  not  of  much 
importance;  for  apart  from  the  securities  known  as  "equip- 
ment notes,"  there  are  very  few  which  fall  within  the  five-year 
to  twenty-year  limits.  The  chapter  which  follows  will  be 
devoted  to  "long-term"  securities,  so  that  nothing  more  need 
be  said  about  them  here. 

Short-term  securities  consist  of  notes,  of  acceptances,  and^ 
of  accounts  payable.  The  notes  are  divided  into  three  well-  — 
marked  classes:  (i)  merchandise  notes,  (2)  notes  discounted 
at  banks,  and  (3)  notes  sold  to  the  public.  For  our  present 
purpose,  we  will  group  accounts  payable,  acceptances,  and 
merchandise  notes  under  the  head  of  "trade  credit."  After 
considering  this  subject,  we  will  take  up  bank  credit  and  notes 
sold  to  the  public.  This  is  a  convenient  division  of  short-term 
borrowing  which  conforms  to  commercial  practice. 

Trade  Credit  y 

The  f^ct  that  all  the  trade  credit  which  a  business  normally  -' 
utilizes  is  in  fact  a  method  of  borrowing  capital,  seems  to  be 
overlooked;  yet  it  is  the  chief  source  of  capital  in  many  con- 
cerns which  do  a  trading  business.  There  are  literally  tens 
of  thousands  of  small  merchants  throughout  the  country  who 
customarily  buy  nearly  all  their  stock  in  trade  on  credit,  and 
whose  own  capital  is  no  more  than  sufficient  to  cover  the  pur- 
chase of  store  fixtures  and  perhaps  some  small  advances  on 
their  first  orders  as  a  guarantee  of  their  good  faith.  It  is  out 
of  the  question  for  them  to  pay  their  accounts  with  the  whole- 
salers from  whom  they  buy,  until  after  they  have  sold  the 
goods  and  thus  have  secured  cash  funds  from  their  customers, 
^^^ery  often  the  wholesaler  in  his  turn  is  "carried"  to  a  great 

t—— 


112  CAPITAL 

his  proportion  of  owned  capital,  however,  is  Hkely  to  be  much 
higher  than  the  retailer's  proportion.  Going  one  step  further 
back  we  reach  the  manufacturer  with  whom  trade  credit  is 
comparatively  a  minor  source  of  funds.  Thus  we  have  the 
whole  process  of  selling  goods  through  the  ordinary  trade 
channels  financed  to  a  considerable  extent  by  the  extension  of 
credit.  The  ultimate  customer  is  the  only  man  in  the  chain 
who  pays  cash — and  even  the  customer  may  in  his  turn  be 
living  on  trade  credit.  As  the  customer  pays  for  his  purchases, 
the  retailer  is  able  to  collect  current  funds  which  he  transmits 
to  the  wholesaler,  who  in  turn  pays  the  manufacturer  and 
jobber. 

The  extent  to  which  trade  credit  is  granted,  depends  chiefly 
upon  the  nature  of  the  goods  that  are  being  retailed,  and  on 
the  ability  of  the  ultimate  consumer  to  pay  promptly.     Some- 
times extreme  instances  are  found  in  which  a  whole  community 
or  a  whole  country  is  doing  business  largely  on  "trade  credit.'' 
In  Argentina,  for  example,  during  the  several  years  preceding 
the  beginning  of  the  European  War  in  19 14,  all  trade  was 
handled  on  the  basis  of  long  credit.     The  importer  of  manu- 
factured articles  had  become  accustomed  to  receiving  90-day 
drafts  (which  is  the  usual  term  of  drafts  representing  ship- 
ments from  Europe  or  the  United  States  to  South  Americai 
countries),  and  these  drafts  he  was  frequently  able  to  rene'' 
for  a  like  period;  so  that  the  importer  was  getting  thre< 
months'  to  six  months'  credit  on  all  his  purchases.     The  imj 
porter  in  turn  sold  to  country  storekeepers  on  "open  account' 
and  was  compelled  to  wait  for  his  payment  until  the  storej 
keeper  could  collect  from  his  customers.    The  customers  wer^ 
for  the  most  part  land  owners  who  had  funds  only  at  on^ 
season  of  the  year,  after  the  sale  of  their  crops;  consequentl] 
the  storekeeper  was  in  the  habit  of  securing  three  months'  t( 
nine  months'  terms  for  himself.    Thus  all  business  was  beini 
done  on  "long  credit"  and  the  proportion  of  owned  capitc 


BORROWED   CAPITAI^SHORT-TERM  II3 

invested  in  retail,  wholesale,  and  importing  houses  was  ab- 
normally small.  By  reason  of  the  wonderful  resources  and 
prosperity  of  the  country,  this  system  worked  fairly  well  for 
a  number  of  years  and  made  possible  enormous  profits  in  all 
lines  of  trade.  Its  danger  was  shown,  however,  when  suc- 
cessive poor  crops  in  19 12  and  191 3  impaired  the  paying  ability 
of  the  Argentine  farmer  and  led  to  an  enormous  number  of 
mercantile  failures.* 

Much  the  same  situation  and  practices  existed  in  the  United 
States  a  generation  or  more  back.  Prior  to  the  Civil  War, 
purchases  of  merchandise  were  customarily  settled  by  notes 
running  six,  eight,  or  ten  months  and  sometimes  longer.  This 
was  due  to  the  fact  that  buyers  came  to  market  only  once  or 
twice  a  year,  and  then  purchased  their  entire  stock  for  the 
season,  the  buyers  giving  their  notes  which  were  readily  in- 
dorsed and  discounted.  These  were  usually  met  out  of  the 
proceeds  of  the  sale  of  the  goods  to  the  ultimate  consumer. 
The  Civil  War  upset  this  system.  During  the  war  and  for 
some  years  after,  merchandise  business  came  down  to  a  basis 
of  cash  or  of  credit  of  only  ten  to  thirty  days.  When  the 
next  great  expansion  of  trade  took  place  in  the  early  8o's, 
the  increased  confidence  of  sellers  resulted  in  offering  some- 
what longer  terms  of  credit,  but  these  terms  were  combined 
with  offers  of  liberal  discount  for  cash  payments,  which  is 
the  custom  in  most  lines  today.  The  discounts  were  so  attrac- 
tive that  retail  merchants  in  good  standing  began  to  borrow 
from  their  local  banks  in  order  to  take  advantage  of  them. 
Thus  the  present  practice  of  taking  discount  for  cash  was 
established ;  and  prices  are  now  made  with  that  understanding. 
The  high  rates  of  discount  are  now  in  the  nature  of  a  penalty 
imposed  on  a  merchant  who  takes  the  long  terms  which  are 
nominally  at  his  disposal.    This  change  in  custom  of  payment 

*For  a  more  detailed  study  of  this  situation  see  the  authors  report  on  "Financial 
Developments  in  South  American  Countries,"  issued  b>  the  Bureau  of  Foreign  and 
Domestic  Commerce,  Washington,  D.  C. 


114  CAPITAL 

was  accompanied  by  the  introduction  of  the  commercial 
traveler,  selling  from  sample  in  comparatively  small  lots.  The 
process  has  been  helped  somewhat  by  the  standardization  of 
goods  and  selling  methods,  and  the  quicker  turnover  which 
has  now  become  possible.* 

For  these  reasons,  trade  credit  in  this  country  is  relatively 
less  important,  and  bank  credit  is  more  important,  than  was  i 
formerly  the  case.  Another  factor  which  should  be  mentioned 
as  contributing  powerfully  to  this  result  is  the  decentralized 
banking  system  of  the  United  States,  which  puts  one  or  more 
local  banks  at  the  door  of  every  merchant  and  makes  it  com- 
paratively easy  for  him  to  secure  and  utilize  bank  credit. 

The  European  system  of  financing  merchandise  purchases 
rests  upon  the  use  and  discounting  of  accepted  drafts  which 
are  in  effect  two-name  promissory  notes.  The  wholesaler 
draws  a  time  draft  upon  the  retailer  which  accompanies  the 
shipment  of  goods.  The  retailer  writes  or  stamps  his  accep- 
tance on  the  draft  across  its  face  and  returns  it  to  the  whole- 
saler who  is  then  in  position  to  discount  it  with  his  bank. 
This  is  a  method  of  financing  merchandise  transactions  which, 
from  the  banker's  standpoint,  has  a  number  of  advantages,  the 
chief  of  which  is  that  every  accepted  draft  represents  an  actual 
transfer  of  goods,  and  the  banker  is  not  compelled  to  lend,j 
therefore,  merely  on  the  strength  of  the  general  credit  stand- 
ing of  his  customer.  An  effort  is  now  being  made,  undei 
the  guidance  of  the  Federal  Reserve  Board,  to  introduce  thij 
system  in  the  United  States.  Although  the  movement  is  oJ 
genuine  importance,  we  need  not  for  our  purposes  considei 
it  further.  It  is  closely  similar  to  the  custom  which  prevail* 
in  certain  lines  of  business  of  giving  notes  in  payment  foi 
purchases  of  merchandise. 

Some  of  the  principal  lines  in  which  note-giving  is  stil 


•See  an  excellent  article  entitled  "Proposal  to  Dehumanize  Trade,"  by  E.  D.  Paj 
in  New  York  Annalist^  March  16,  1914. 


BORROWED   CAPITAL— SHORT-TERM 


115 


common  are  harvesting  machines,  plumbers'  supplies,  book 
printing  and  binding,  and  electric  trolley  supplies.  In  most 
other  lines,  however,  goods  are  sold  on  open  account  and  notes 
are  asked  for  only  when  the  sale  is  made  to  a  weak  concern. 
Sellers  are  often  so  anxious  to  dispose  of  their  products,  and 
it  is  consequently  so  easy  for  established  firms  that  have  a 
clean  record  behind  them  to  secure  whatever  goods  they  re- 
quire on  terms  of  30  to  90  days  or  even  longer,  that  trade 
credit  may  almost  insensibly  become  a  real  source  of  danger. 
It  is  a  delicate  instrument  which  requires  to  be  handled  with 
watchfulness.  A  little  carelessness  in  failing  to  meet  trade 
accounts  on  the  day  they  fall  due  may  be  sufficient  to  give  a 
concern  the  reputation  of  being  "slow  pay,*'  and  thus  may 
damage  not  only  its  credit  with  the  firms  from  which  it  buys, 
but  also  its  credit  with  banks  as  well  as  its  general  business 
standing. 

On  the  other  hand,  there  is  undoubtedly  such  a  thing  as 
being  overzealous  in  paying  up  trade  accounts.  Not  only  is 
there  an  actual  loss  of  capital  to  the  extent  of  the  difference 
between  a  normal  amount  of  trade  credit  and  the  amount 
which  the  company  secures,  but  there  is  also  to  be  considered 
the  fact  that  the  habit  of  paying  accounts  ahead  of  time,  once 
it  has  been  formed,  cannot  be  easily  broken.  The  writer  has 
in  mind  one  concern  which  started  in  business  with  ample 
funds.  The  treasurer  saw  no  reason  why  he  should  utilize 
the  credit  of  the  firm  and  paid  all  bills  in  cash  as  they  were' 
presented,  even  though  he  obtained  no  discount.  A  year  or 
two  later  the  expansion  of  the  company's  business  reduced  the 
available  cash,  and  the  treasurer  began  to  take  the  full  term 
of  payment  to  which  he  was  entitled.  Immediately  some  of 
his  creditors  became  suspicious  as  to  the  solvency  of  the  com- 
pany, and  rumors  spread  about  which  were  so  serious  that 
it  was  necessary  to  bring  more  cash  into  the  concern  and 
resume,  for  the  time  being  at  least,  the  prompt  payment  of 


Il6  CAPITAL 

bills.  Thereafter  the  company  proceeded  by  slow  degrees  to 
utiHze  the  full  line  of  trade  credit  to  which  it  was  entitled. 
There  is  much  truth  in  the  remark  that  the  only  way  to  acquire 
credit  is  to  make  use  of  it. 

Bank  Credit 

It  has  already  been  noted  that  it  is  customary  in  this  country 
for  merchandising  firms  to  take  advantage  of  cash  discounts 
in  paying  for  their  purchases  and  to  secure  the  funds  with 
which  to  make  immediate  payments  by  borrowing  from  their 
own  banks.  •  This  practice  spread  throughout  the  country  be- 
ginning in  the  8o's,  but  it  originated  in  New  York  several 
years  before.  Shortly  after  the  crisis  of  1873,  the  late  presi- 
dent of  the  Importers  and  Traders  National  Bank  in  New 
York  City,  Mr.  Buell,  rapidly  built  up  the  business  of  his 
institution  by  showing  his  customers  how,  by  borrowing  from 
his  bank  on  their  own  single-name  paper,  they  could  obtain 
cash  prices  or  cash  discounts  and  thus  show  a  substantial  profit 
on  their  interest  and  discount  accounts  for  the  year.  The  cus- 
tom is  now  so  firmly  established  that  practically  every  business 
concern  in  good  standing  counts  on  establishing  a  line  of 
credit  with  its  bank  which  will  enable  it  to  borrow  simply  by 
drawing  its  own  notes  and  depositing  them  with  the  bank. 

A  variation  in  this  custom  exists  among  large  manufactur- 
ing and  commercial  corporations  which  often  find  it  ad-_ 
vantageous  to  turn  over  their  own  notes  to  brokers  who  foi 
a  small  commission  sell  them  to  any  bank  that  may  happei 
to  have  idle  funds  available.  The  note  brokers  sell  the  papei 
of  large  concerns  throughout  the  country.  At  the  time  of  th( 
failure  of  the  Booth  Fisheries  Company  some  years  ago,  am 
at  the  time  of  the  more  recent  failure  of  the  H.  B.  Claflfr 
Company  and  associated  concerns,  it  was  found  that  the  notes 
of  these  companies  were  scattered  among  banks  throughout 
the  United  States.    The  banker  who  buys  a  single-name  not< 


BORROWED   CAPITAL— SHORT-TERM 


117 


from  a  broker,  very  often  has  no  knowledge  whatever  of  the 
financial  affairs  of  the  company  which  issues  the  note.  He 
may  have  heard  the  name  of  the  company  frequently  and  he 
probably  considers  the  note  broker  a  good  fellow  in  whose 
honesty  and  judgment  he  has  confidence,  and  that  is  the  extent 
of  the  actual  information  before  him  when  he  makes  his  pur- 
chase. This  loose  method  of  doing  business  has  brought 
some  protest  and  is  likely  to  be  improved  in  part  during  the 
next  few  years. 

A  few  large  concerns  which  sell  their  short-term  notes  in 
the  open  market  on  a  large  scale,  headed  by  the  International 
Paper  Company,  have  instituted  the  custom  of  having  all  their 
notes  registered  by  a  trust  company,  just  as  bonds  are  reg- 
istered. This  has  at  least  the  advantage  of  making  it  easy 
to  ascertain  how  many  notes  a  company  has  outstanding  at 
any  one  time,  thus  avoiding  gross  overissues.  A  second  im- 
portant improvement  is  to  be  made  a  feature  of  the  Federal 
Reserve  banking  system.  It  "is  the  intention  to  place  a  com- 
plete record  of  the  note  obligations  of  all  important  concerns 
in  the  hands  of  members  of  the  system.  This  record  will,  of 
course,  include  references  to  any  defaults  of  bills  in  payment. 
In  the  course  of  a  few  years  it  will  become  a  highly  valuable 
aid  to  bank  examiners  and  to  the  Federal  Reserve  officers  in 
checking  up  the  credit  standing  of  borrowing  companies. 

One  accepted  rule  which  should  be  observed  by  corpora- 
tions that  sell  their  notes  through  brokers,  is  that  they  should 
not  at  the  same  time  be  discounting  any  large  quantity  of 
notes  with  their  own  banks.  If  they  are  using  both  banks 
and  note  brokers,  they  have  no  quick  method  of  raising  funds 
open  to  them  in  an  emergency.  If  they  are  using  either  their 
own  banks  alone  or  note  brokers  alone,  then  they  can  turn, 
if  it  should  become  necessary,  to  the  method  that  has  not 
previously  been  utilized. 

The  abuse  of  bank  credit  has  long  been  a  weak  feature  in 


Il8  CAPITAL 

modern  business  life,  and  will  not  quickly  be  eliminated.  It 
,  may  arise  in  two  ways :  either  by  making  a^  wrong  application 
of  the  funds  secured  from  the  bank,  or  by  obtaining  the  funds 
on  the  strength  of  false  or  questionable  claims.  There  are 
three  legitimate  reasons  for  making  bank  loans :  first,  to'  finance 
a  temporary  shortage  of  funds;  second,-  to  increase  the  stock 
of  salable  goods  on  hand;  third,  to  extend  additional  credit 
to  customers.  The  first  reason  may  be  quite  acceptable,  but 
only  under  exceptional  circumstances.  A  firm,  for  instance, 
may  have  suffered  a  loss  by  fire  and  have  insurance  payments 
shortly  due,  in  anticipation  of  which  it  may  properly  borrow 
from  its  bank ;  or  it  may  have  funds  shortly  coming  in  from  its 
stockholders  or  from  other  sources.  Each  case  of  this  kind 
must  be  decided  on  its  own  merits.  The  second  reason  is 
the  one  that  is  customary  and  that  is  generally  considered 
soundest.  It  is,  of  course,  necessary  for  both  the  borrower 
and  the  bank  to  be  reasonably  certain  that  the  goods  being 
purchased  are  salable,  so  that  there  may  be  no  question  as  to 
meeting  the  note  out  of  the  proceeds  of  the  sale.  The  third 
reason  is  also  concerned  with  the  sale  of  goods,  but  this  time 
from  the  standpoint  of  the  seller.  It  is  necessary  here  for 
both  the  borrower  and  the  bank  to  make  sure  that  the  credit 
which  is  being  extended  to  customers,  is  well  placed  and 
sound. 

If  the  borrower,  instead  of  using  the  funds  he  receivej 
from  the  bank  for  one  of  the  three  purposes  above  mentioned] 
utilizes  it  in  extending  his  plant  in  the  purchase  of  non-salabl< 
goods,  in  general  advertising,  or  puts  it  into  any  other  propert] 
or  expenditure  that  is  not  readily  convertible  into  cash,  h( 
may  properly  be  said  to  be  abusing  the  trust  of  his  banker^ 
More  than  that,  he  is  seriously  jeopardizing  his  own  financi; 
safety.  "What  difference  does  it  make  to  the  banker  whethei 
I  use  his  money  in  one  way  or  another?"  is  the  answer  oi 
some  business  men,  "sooner  or  later  he  will  get  his  monei 


BORROWED   CAPITAL— SHORT-TERM 


119 


back  with  interest,  and  that's  all  he  needs  to  fret  about." 
Yes,  but  the  banker  is  not  in  the  business  of  making  long-term 
loans  or  loans  that  may  be  sound  enough  but  cannot  be  paid 
back  on  the  dot.  The  only  safe  banking  is  short-term  banking, 
and  he  is  absolutely  right  when  he  insists  that  his  loans  be 
used  only  in  quick  turns  and  not  for  permanent  or  uncertain 
investments. 

The  other  abuse  of  bank  credit  is  best  illustrated  by  the 
great  Claflin  failure  in  New  York  in  the  summer  of  19 14. 
On  account  of  the  high  standing  of  the  Claflin  firm  for  gen- 
erations, and  its  unquestioned  credit,  it  was  permitted  to  dis- 
count many  millions  of  dollars  of  paper  issued  by  its  sub- 
sidiary corporations.  It  was  learned  after  the  failure,  that 
much  of  this  paper  did  not  represent  actual  commercial  trans- 
actions. It  was  simply  put  out  more  or  less  at  random  when 
the  firm  needed  money.  The  H.  B.  Claflin  Company's  con- 
tingent liabilities  were  never  reported;  in  fact,  no  complete 
financial  statements  were  given  to  bankers.  In  the  absence  of 
financial  statements  and  of  any  definite  form  of  assurance  that 
single-name  notes  or  notes  issued  by  one  subsidiary  company 
to  another  subsidiary  company  in  the  same  organization  are 
representative  of  commercial  transactions,  there  is  really  no 
method  of  telling  whether  a  corporation  is  borrowing  beyond 
the  limits  of  safety  or  not. 

As  is  pointed  out  more  fully  on  page  124,  most  banks  are 
now  beginning  to  insist  quite  properly  on  receiving  financial 
statements.  A  committee  of  the  New  York  Clearing  House 
has  suggested  that  a  form  of  promissory  note  be  devised,  the 
signature  to  which  certifies  that  the  document  is  the  product 
of  a  commercial  transaction.  The  suggestion  has  merit,  and 
with  the  strong  backing  of  important  banks  behind  it,  might 
eventually  be  adopted.  In  this  connection  it  might  be  well  to 
say  a  word  as  to  "accommodation"  indorsements  of  commer- 
cial paper.     This  practice,  which  was  formerly  so  prevalent 


I20  CAPITAL 

among  individuals,  is  gradually  dying  away.  There  have  been 
many  instances  of  indorsers  having  suffered  heavy  losses 
simply  because  they  were  weak  enough,  or  good-natured 
enough,  to  lend  their  credit  to  their  acquaintances.  Sometimes 
a  corporation  is  guilty  of  lending  its  name  in  the  same  way, 
and  with  even  less  excuse.  In  fact,  an  indorsement  by  a  cor- 
poration for  accommodation  is  probably  illegal,  and  would  not 
be  held  good  in  most  jurisdictions.  A  corporation  is  organized 
to  carry  on  a  certain  line  of  business,  for  which  it  is  granted 
definite  powers  under  its  charter.  It  is  probably  not  within 
the  legal  power  of  any  corporation  to  assume  the  responsibility 
which  goes  with  an  indorsement  given  without  consideration. 

Bank  Collateral 

We  have  spoken  In  the  preceding  section  of  bank  credit 
as  if  It  were  always  obtained  on  the  strength  of  a  firm's  general 
standing.  This  is,  in  fact,  the  case  when  a  concern  borrows 
simply  by  giving  its  unsecured  note,  and  even  when  it  indorses 
and  discounts  a  note  which  it  has  received  from  some  customer 
who  is  practically  unknown  to  the  bank.  Bank  credit  is  even 
more  extensively  obtained,  however,  when  it  is  directly  backed 
by  collateral  security  of  some  kind.  Such  loans  are  more 
easily  granted,  not  only  because  the  banker  calculates  that  he 
is  secured  against  loss,  but  also  because  he  has  a  better  check 
on  the  uses  to  which  his  money  is  to  be  put. 

Collateral  may  be  conveniently  classified  under  three 
heads : 

A  Stocks  and  Bonds 
2>  Merchandise 
(^  Bills  and  Accounts  Receivable 

^  The  first  of  these  three  classes  is  the  banker^s  favorite,  at 
least  in  the  United  States.  This  is  due  to  the  fact  that  stocks 
and  bonds  are  usually  salable,  so  that  in  case  of  default  on  the 


BORROWED   CAPITAL— SHORT-TERM  121 

part  of  the  borrower,  the  banker  should  have  little  difficulty  in 
disposing  of  the  collateral  and  repaying  most  or  all  of  his 
advances.  This  statement  is  not  to  be  taken  as  applying  in- 
discriminately, to  be  sure,  to  all  stocks  and  bonds;  for  the 
securities  of  some  local  or  little  known  companies,  even  though 
the  companies  may  be  carrying  on  a  successful  business,  are 
about  as  unmarketable  property  as  can  be  mentioned.  At  the 
other  extreme  are  the  active  securities  of  the  great  corpora- 
tions which  are  being  daily  bought  and  sold  in  large  quantities 
on  the  New  York  and  other  stock  exchanges;  these  are  the 
securities  that  serve  as  collateral  for  the  enormous  amounts 
of  call  loans  kept  outstanding  by  the  banks  of  the  New  York 
financial  district.  Between  the  two  extremes  there  are  many 
sound  securities  which  the  banker  regards  as  at  least  fairly 
marketable,  and  which  he  is  willing  to  take  as  collateral.  Some 
of  these  securities  are  owned  by  commercial  and  manufactur- 
ing corporations  which  may  properly  use  them  as  a  basis  for 
bank  credit.  There  is,  however,  a  limitation  to  be  noted  here. 
It  is  not  regarded  as  sound  practice  for  a  corporation  to  post 
as  collateral  the  stock  of  a  subsidiary  company.  In  the  first 
place,  the  stock  probably  has  no  active  market  and  the  bank 
will  accept  it  only  reluctantly  and  when  it  is  mixed  with  some 
salable  collateral,  and,  in  the  second  place,  the  corporation 
should  not  be  compelled  to  take  any  chances — even  remote 
chances — of  losing  control  of  an  essential  piece  of  property. 
The  securities  of  subsidiary  companies  may  serve  properly  as  ^ 
collateral  for  long-term  bond  issues,  but  not  as  collateral  for 
bank  loans. 

Merchandise  serves  as  collateral  when  a  company  posts 
warehouse  receipts,  bills  of  lading,  or  specific  liens  upon 
specific  pieces  of  its  personal  property  as  collateral.  The  first- 
named  case  is  the  one  that  is  most  common.  Millions  of  dollars 
of  holdings  of  cotton,  wheat,  and  other  grains  are  carried  in 
this  way  every  year  following  the  harvesting  of  the  crops. 


122  CAPITAL 

Once  in  a  while  manufacturing  corporations  may  have  col- 
lateral of  this  nature,  as  when  a  steel  manufacturing  company 
holds  pig  iron,  but  this  is  unusual.  Bills  of  lading  indorsed 
to  the  order  of  the  bank  commonly  serve  as  collateral  for 
drafts  discounted  by  the  seller  of  merchandise.  Millions  of 
dollars  worth  of  grain,  live  stock,  and  other  goods  in  transit 
are  in  this  way  utilized  as  backing  for  loans  made  by  the  banks, 
and  accepted  as  collateral  up  to  a  fair  proportion  of  their  face 
value  for  direct  bank  loans.  This  is  particularly  true  in  the 
export  trade  where  the  banker  does  not  feel  sure  enough  of 
the  standing  of  the  drawer  of  the  draft  or  of  the  salability 
of  the  merchandise  to  risk  discounting  the  whole  draft,  but 
is  willing  to  make  advances  up  to,  say,  50,  60,  80%  or  more 
of  its  face  value.  This  is  true  also  when  the  merchandise  con- 
sists of  goods  that  are  perishable  or  that  do  not  have  a  ready 
market.  A  draft  covering  a  shipment  of  fruit,  for  instance, 
might  not  be  readily  discounted,  but  several  of  these  drafts 
would  be  regarded  as  good  collateral  for  an  advance  of  say 
50  to  75%  against  their  face  value.  Liens  on  specific  pieces 
of  personal  property  are  not  common,  but  may  at  times  be 
perfectly  good  banking  collateral. 

Accounts  receivable  fall  into  a  different  class.  The  evi- 
dence of  indebtedness  of  a  third  party  to  the  borrower  is  so 
uncertain  and  the  claims  upon  specific  property  are  so  indirect, 
that  accounts  receivable  are  not  customarily  accepted  as  sound 
collateral  for  a  bank  loan.  It  is  considered  better  for  the 
company  to  borrow  on  its  general  credit  rather  than  to  assign 
its  accounts  receivable  as  collateral.  Yet  this  customary  rule 
appears  to  be  based  nearly  as  much  upon  prejudice  as  upon 
careful  investigation.  As  a  result  of  the  unwillingness  of  most 
banks  to  accept  assignments  of  accounts  receivable  as  col- 
lateral, a  considerable  number  of  financing  and  discount  houses 
have  come  into  prominence  during  the  last  few  years.  These 
houses  make  a  specialty  of  advancing  money  against  open  ac- 


BORROWED   CAPITAL— SHORT-TERM  123 

counts.  It  will  be  more  convenient  to  discuss  their  methods 
and  activities  at  some  length  a  httle  later  when  we  come  to 
consider  working  capital.  For  the  present,  it  is  enough  to 
note  that  during  the  sudden  and  severe  crises  produced  in  the 
United  States  in  the  fall  of  19 14  by  the  outbreak  of  the 
European  War,  the  influence  of  these  discount  houses  was 
perceptibly  increased.  They  customarily  charge  an  interest  of 
6%,  plus  a  commission  of  i  or  2%.  They  ordinarily  allow 
interest  to  the  customer  on  all  items  as  fast  as  collected,  and, 
inasmuch  as  they  carry  no  deposits,  they  do  not  follow  the 
banking  custom  of  requiring  that  20  to  25%  of  the  proceeds 
of  a  loan  remain  on  deposit  without  interest.  They  usually 
make  advances  up  to  about  80  to  85%  of  the  face  value  of  the 
receivables  that  have  been  assigned.  The  example  of  these 
discount  houses  has  recently  been  followed,  within  moderate 
limitations,  by  some  of  the  more  progressive  mercantile  banks. 
The  old  prejudice  against  "hocking"  accounts  appears  to  be 
fading  away. 

Factors  Considered  by  Banks  in  Making  Loans 

The  underlying  principles  followed  by  the  banker  in  ex- 
tending credit  have  been  touched  upon  in  the  two  preceding 
sections.  It  is  important  to  bear  in  mind  particularly,  first,  that 
the  commercial  banker  must  confine  himself  to  making  'short- 
term  loans;  second,  that  he  should  satisfy  himself  that  the 
money  he  loans  is  to  be  invested  in  such  a  way  that  it  can 
readily  be  reconverted  into  cash;  third,  that  credit  granted 
on  the  general  standing  of  a  business  enterprise  entitles  the 
banker  to  full  and  detailed  knowledge  of  the  inside  workings 
of  the  enterprise;  fourth,  that  collateral,  to  be  acceptable, 
should  consist  either  of  securities  and  merchandise  which  are 
readily  salable,  or  of  drafts  and  accounts  receivable  which 
^are  quickly  convertible  into  cash. 

Supplementing  these  four  basic  principles,  there  are  some 


124  CAPITAL 

observations  to  be  made  at  this  point  as  to  factors  which  are 
taken  into  consideration  by  banks  in  making  loans.  First  of 
all,  attention  should  be  directed  to  the  growing  custom  of 
-requiring  detailed  financial  statements  of  customers  to  be  filed 
from  time  to  time.  There  was  a  time  in  this  country  not  many 
years  ago  when  a  bank's  request  for  such  a  statement  was 
looked  upon  by  the  customer  as  in  the  nature  of  an  affront 
or  an  impertinence.  This  is  even  yet  the  case  in  some  sections 
of  the  United  States,  and  is  notably  true  in  South  America. 
However,  this  feeling  is  rapidly  giving  way  to  the  saner  idea 
that  a  bank  is  certainly  entitled  to  reasonably  accurate  and  full 
information  as  to  any  concern  to  which  it  is  lending  money, 
and  that  it  is  to  the  interest  of  conservative  borrowers  to 
comply  with  the  bank's  request  for  statements  and  thus  put 
itself  in  a  different  class  from  non-conservative  borrowers  who 
are  inclined  to  be  secretive.  The  banks  themselves  are  more 
and  more  inclined  to  insist  not  only  on  complete  statements, 
but  also  on  statements  certified  by  public  accountants.  Such  a 
suggestion  is  not  intended  as  a  reflection  on  the  honesty  or 
capability  of  the  corporation's  own  accounting  force;  it  simply 
brings  to  bear  in  addition  the  judgment  of  an  unbiased  per- 
son of  wide  experience  who  is  in  a  far  better  position  to 
value  assets  than  any  officer  or  employee  of  the  corpora- 
tion. 

That  banks  are  in  favor  of  certified  statements  is  plain 
from  the  answers  received  to  a  circular  letter  sent  out  in 
March,  19 14,  by  the  American  Association  of  Public  Ac- 
countants, asking  for  bankers'  opinions  on  this  point.  The 
844  replies  were  distributed  as  follows: 

Strongly  in  favor 121 

Favorable   501 

Opposed 15 

Strongly  opposed 5 

Non-committal 202 


BORROWED   CAPITAI^SHORT-TERM 


125 


Among  the  factors  considered  by  banks  in  making  loans, 
must  necessarily  be  the  legal  restrictions  in  force  or  likely  " 
soon  to  be  in  force.  The  banking  law  which  went  into  effect 
in  19 14  provides  that,  "any  Federal  Reserve  Bank  may  dis- 
count notes,  drafts,  and  bills  of  exchange  arising  out  of  actual 
commercial  transactions/'  The  effect  of  this  law  is  to  increase  • 
the  value  of  two-name  paper,  accepted  drafts,  and  other  evi- 
dences of  debt,  which  are  the  direct  results  of  commercial 
transactions,  and  correspondingly  to  decrease  somewhat  the 
value  of  paper  which  is  not  available  for  rediscounting  at 
Federal  Reserve  Banks.  Under  this  law,  the  paper  issued  by 
one  subsidiary 'company  to  a  holding  company  as  an  accom- 
modation note — such  as  the  30  to  40  million  dollars  of  Claflin 
notes  previously  referred  to — would  not  be  available  for  re- 
discounting.  One  result  of  the  collapse  of  the  Claflin  firm 
was  to  strengthen  greatly  the  movement  in  favor  of  putting 
a  premium  upon  paper  which  arises  out  of  commercial  trans- 
actions. 

The  Federal  Reserve  system  also  favors  the  policy  of  get- 
ting more  written  information  than  has  heretofore  been  re- 
quired from  customers  in  making  applications  for  loans.  Not 
only  will  paper  based  upon  certified  financial  statements  be 
favored  in  the  rediscounting  operations  of  the  Federal  Reserve 
Bank,  but  also  there  will  probably  be  a  strong  tendency  to 
insist  that  some  evidence  be  given  that  bank  loans  are  "self-  -^ 
liquidating"  and  that  some  assurance  be  extended  that  the 
loans  are  not  to  be  used  for  permanent  improvements  to  plants 
and  the  like. 

Among  the 'unwritten  rules  that  have  long  been  customary 
among  bankers  in  making  loans,  these  two  are  of  chief  im- 
portance: First,  at  least  20%  of  the  bank  loans  should  be  " 
retained  as  a  deposit  in  the  bank,  the  other  80%  only  being 
available  for  meeting  obligations.  This  is  a  long  standing 
custom,  but  is  not  universal.     It  is  more  strictly  applied  by 


126  CAPITAL 

some  banks  and  in  some  lines  of  business  than  in  others. 
''Second,  all  bank  loans  should  be  "cleaned  up"  at  least  once  a 
year  so  that  the  bank  may  make  sure  that  the  money  it  lends 
is  not  going  into  permanent  investments.  This  is  especially 
necessary  in  those  lines  of  business  which  have  well  marked 
seasons  of  activity.  It  would  be  clearly  inadvisable  for  a  bank 
to  allow  a  customer  in  such  a  line  credit  for  the  coming  season 
until  after  he  has  paid  up  his  loans  for  the  previous  season. 
With  manufacturing  corporations  the  rule  is  not  so  strictly 
applied;  yet,  even  here  it  is  properly  thought  to  be  desirable 
that  the  company's  balance  sheet  should  once  in  a  while  be 
wiped  clear  of  bank  loans.  If  this  cannot  be  done,  it  is  clear 
enough  evidence  that  the  company  is  using  bank  funds  as  a 
part  of  its  permanent  capital,  and  that  it  should  be  reinforced 
by  the  sale  of  more  stock  or  long-term  securities. 

All  these  rules  of  successful  and  conservative  banking  are 
also  the  rules  of  successful  and  conservative  financing  of  all 
business  corporations  which  borrow  from  banks.  There  is  no 
conflict  whatever  between  the  two  points  of  view.  A  banker 
wishes  in  normal  times  to  lend  as  much  as  he  can  safely 
place;  the  treasurer  of  a  borrowing  corporation  wishes  to 
borrow  as  much  as  is  consistent  with  safety.  In  theory  there 
should  never  be  a  disagreement  or  a  hitch  between  them. 
However,  the  frailties  of  human  nature  are  not  so  easily  set 
aside.  A  treasurer's  prejudices  and  fancied  interests  fre- 
quently lead  him  to  oppose  reasonable  requests  and  criticisms ; 
on  the  other  hand,  a  banker  is  at  least  equally  liable  to  suffer 
from  obstinate  prejudices.  Recently  an  eastern  manufacturer 
asked  his  banker  for  a  loan  of  $25,000.  'T  see,"  said  the 
banker  looking  over  the  manufacturer's  statement,  "that  your 
advertising  expense  for  last  year  just  about  equals  $25,000. 
If  you  would  cut  off  your  advertising  you  would  have  all  the 
money  you  need."  The  manufacturer  tried  to  explain  that  it 
was  necessary  for  him  to  advertise  in  order  to  sell  his  goods, 


BORROWED   CAPITAL-SHORT-TERM  1^7 

and  that  the  money  borrowed  from  his  bank  was  required  in 
order  to  purchase  raw  materials  which  would  be  quickly  manu- 
factured into  salable  articles.  But  the  banker  had  a  prejudice 
against  advertising  which  nothing  could  shake.*  The  banker's 
work  has  a  tendency  to  make  him  a  slave  to  routine  and  to 
fixed  ideas,  which  are  obstacles  to  the  prosperity  both  of  his 
customers  and  of  himself. 

Short-Term  Notes  Sold  to  the  Public 

The  exact  line  of  division  between  notes  delivered  to  note 
brokers  and  by  them  sold  to  banks,  and  notes  delivered  to 
private  banking  houses  and  sold  to  the  general  public  may 
seem  somewhat  hazy.  As  a  matter  of  fact,  however,  there 
is  usually  little  difficulty  in  classifying  a  note  as  belonging  in 
one  or  the  other  of  these  two  groups.  A  note  intended  for 
sale  to  bankers  is  seldom  more  than  90  days  and  never  more 
than  six  months,  in  length.  A  note  intended  for  wider  dis- 
tribution is  customarily  from  one  year  to  five  years  in  length. 
As  just  indicated,  the  note  brokers  who  handle  the  sale  of 
the  first  class  are  entirely  different  from  the  stock  and  bond 
brokers  and  private  banking  firms  that  handle  notes  of  the 
second  class. 

Short-term  notes  for  sale  to  the  public  may  be  legitimately 
issued  for  one  of  two  purposes:  either  in  anticipation  of  a 
later  issue  of  long-term  bonds  or  other  securities,  or  in  order 
to  finance  purchases  or  an  improvement  which  is  expected  to 
produce  so  much  new  revenue  that  the  note  issue  can  be  paid 
off  at  maturity  out  of  the  corporation's  Income. 

In  order  to  facilitate  the  repayment,  notes  running  for 
three  to  five  years  or  longer  are  frequently  issued  in  series; 
that  is  to  say,  an  equal  proportion  of  the  note  issue  matures 
each  year.     They  are  in  denominations  ordinarily  of  $1,000, 


*See  article  on  "Advertising  as  a  Bankable  Asset,"  by  Edward  Mott  Woolley,  in 
Printer's  Ink,  October  15,  1914. 


128  CAPITAL 

although  they  are  sometimes  as  low  as  $500  or  even  $100, 
and  they  frequently  go  up  to  $10,000  or  even  $100,000. 

Short-term  notes  have  been  a  feature  of  practically  every 
financial  crisis  since  the  Civil  War  with  the  exception  of 
1884.  This  has  been  due  to  the  desire  of  established  corpora- 
tions to  avoid  refunding  of  long-term  bond  issues  which  fall 
due  during  a  crisis.  This  is  certainly  legitimate  enough  within 
proper  limitations.  In  recent  years,  however,  the  habit  of 
putting  out  note  issues  has  grown  even  among  the  conserva- 
tive companies  to  such  an  extent  that  it  is  regarded  as  a  real 
source  of  danger. 

Note  issues  have  been  utilized  of  late  for  almost  every 
conceivable  purpose  for  which  long-time  bonds  used  for- 
merly to  be  emitted;  for  financing  consolidations,  to  pro- 
cure cash  in  connection  with  liquidations,  to  effect 
segregation  of  corporations.  Approximately  $130,000,000 
in  short-term  notes  were  issued  in  Wall  Street  in  1903- 
1904  in  connection  with  the  "rich  men's"  panic  of  that 
winter.  In  1907  they  aggregated  about  $300,000,000;  in 
1912,  approximately  $500,000,000;  and  over  $550,000,000 
fell  due  in  1914.* 

Until  recently,  short-term  note  Issues  have  been  almost 
universally  successful.  The  railroad  notes  have  generally  been 
refunded  on  maturity  by  bond  issues.  Their  danger,  however, 
is  shown  by  the  experience  of  the  Erie  Railroad  Company  in 
1908.  This  company  had  put  out  one-year  notes  in  the  middle 
of  the  crisis  of  1907,  which  matured  April  8,  1908.  Four 
days  before  maturity  J.  P.  Morgan  and  Company,  as  the  rail- 
road's financial  agents,  published  a  notice  to  the  effect  that  the 
notes  would  be  refunded  provided  they  were  all  deposited  on 
or  before  April  8.  As  some  of  the  notes  were  in  Europe, 
compliance  with  this  request  was  impossible.  The  8th  of  April 
came.    Some  European  notes  were  presented  for  payment  and 

*See  article  on  "A  Rickety  Practice  in  Finance,"  by  William  Z.  Ripley,  in  New 
York  AnnaHst,  April  6,  1914. 


BORROWED   CAPITAI^SHORT-TERM 


1^9 


It  was  announced  that  the  money  for  their  redemption  was 
not  at  hand.  To  all  appearances  another  bankruptcy  was  im- 
pending. Then  suddenly  E.  H.  Harriman,  from  his  sick-bed, 
telephoned  that  he  would  take  the  whole  burden  upon  himself. 
Immediately  he  arranged  for  a  refunding  issue  of  three-year 
notes  and  brought  about  a  satisfactory  redemption  of  the  prev- 
ious issue.  It  was  one  of  the  most  dramatic  incidents  in  the  his- 
tory of  American  finance.  The  occurrence  serves  to  illustrate 
clearly  the  dangers  that  beset  every  corporation  that  relies  too 
much  on  short-term  notes  which  it  cannot  possibly  hope  to 
meet  except  by  issuing  other  securities.  As  was  remarked  by 
Guy  E.  Tripp,  chairman  of  the  Westinghouse  Electric  Manu- 
facturing Company  in  19 14,  *Tt  is  a  bad  thing  to  have  a  debt 
that  you  never  intend  to  pay  and  never  can  pay;  and  that  is 
what  some  short-term  notes  are.'' 

Aside  from  the  danger,  excessive  financing  through  short- 
term  notes  is  apt  to  become  expensive.  The  interest  payments 
may  not  be  high,  but  every  issue  must  be  underwritten,  and 
the  underwriting  commissions  in  a  few  years  become  a  heavy 
burden. 

The  highest  grade  short-term  notes  of  large  railroad  and 
industrial  corporations,  ordinarily  sell  on  a  basis  of  4%  to 
5J^%.  A  specialist  in  these  notes  said  recently  that  he  re- 
garded those  yielding  over  7%  as  the  rankest  kind  of  specula- 
tion, and  "much  more  dangerous  than  active  stocks  which  can 
generally  be  sold  within  one  point  of  previous  sales.  A  loss 
on  a  note  when  it  comes,  is  like  a  fire  loss;  it  is  generally 
total." 

At  the  present  writing,  some  securities  of  this  type  are 
being  quoted  to  yield  as  high  as  10,  12  and  15%.  Some 
buyers  of  these  high-yield  notes  have  made  a  great  deal  of 
money  on  them,  but  they  are  to  be  regarded  as  dangerous 
in  the  extreme  for  any  one  who  is  not  intimately  acquainted 
with  the  issuing  company. 


130 


CAPITAL 


As  the  notes  approach  within  six  months  or  less  of  ma- 
turity, they  come  into  an  entirely  different  class,  for  they  be- 
come available  for  the  use  of  banks.  Hence,  they  sell  at  prices 
which  make  their  yield  approximate  the  yield  of  commercial 
paper  of  the  highest  class.  Sometimes  the  yield  may  be  as 
low  as  ij4  or  2%. 

A  curious  situation  arises  as  a  note  comes  very  close  to 
maturity,  due  to  the  fact  that  fluctuations  of  as  little  as  even 
1/8  or  1/16  in  the  purchase  price  may  make  a  considerable 
difference  in  the  yield ;  consequently,  the  tendency  is  for  such 
notes  nearing  maturity  to  keep  out  of  the  market. 

Some  short-term  notes  are  secured  by  collateral ;  others,  as 
in  the  case  of  the  Pennsylvania  Railroad,  rest  solely  upon  the 
credit  and  reputation  of  the  issuing  company.  Curiously 
enough,  notes  which  command  the  best  price  and  have  the 
broadest  market  have  no  collateral  behind  them.  The  fact 
that  collateral  is  posted  is  looked  upon  as  indicating  that  the 
company  has  already  used  up  all  its  unsecured  credit. 

Professor  Ripley  has  forced  direct  attention  to  what  he^ 
well  calls  "the  most  deceptive  practice"  of  carrying  short 
term  notes  in  corporation  balance  sheets  as  a  portion  of  funde 
debt  instead  of  including  them  among  the  current  liabilitiesj 
This  has  been  true  even  of  corporations  of  the  standing  of 
the   Erie  Railroad,   and   the   Baltimore   and   Ohio   Railroad 
Notes  running  as  long  as  4  or  5  years  are  not,  it  is  true,  i 
exactly  the  same  class  as  bank  loans  and  accounts  payable, 
most  of  which  fall  due  within  30  to  90  days,  but  they  are  b 
no  means  a  funded  obligation.    They  must  be  met  either  oui 
of  income  or  by  the  issuance  of  long-term  loans.     They  ar 
properly  offset  and  secured,  as  we  shall  see  a  little  later,  no 
by  the  permanent  property  and  investments  of  the  issuin 
corporations,  but  by  the  assets  which  are  readily  convertibl 
into  cash. 


I 


CHAPTER    VII 

BORROWED  CAPITAL— EONG-TERM 

Bonds  and  Mortgages 

There  is  a  fundamental  difference — as  will  be  emphasized 
from  time  to  time  in  this  volume — between  short-term  borrow- 
ing and  long-term  borrowing.  While  they  tend  in  certain 
isolated  cases  to  merge  into  each  other,  the  distinction,  as  has 
already  been  pointed  out,  is  for  practical  purposes  clearly 
marked. 

The  simplest  form  of  long-term  or  "funded"  borrowing  is  - 
the  ordinary  mortgage  on  real  estate  or,  as  it  is  more  correctly 
called,  the  bond  and  mortgage.  The  form  of  this  instrument 
is  almost  as  ancient  as  law  itself.  It  purports  to  be  a  transfer 
of  the  title  to  a  piece  of  real  estate  from  the  former  owner 
to  a  new  owner,  with  the  proviso,  however,  that  the  title 
may  be  redeemed  by  the  former  owner  by  his  repayment,  at 
maturity,  of  an  acknowledged  debt  which  he  obligates  or. 
"bonds"  himself  to  repay.  Although  this  is  the  immemorial 
form,  the  instrument  does  not,  as  a  matter  of  practice  and  of 
legal  interpretation,  actually  convey  ownership  of  the  property 
cited;  its  effect,  in  spite  of  the  wording  of  the  mortgage,  is 
merely  to  pledge  the  property  as  security  for  the  repayment  of 
the  loan.  There  are  varying  forms  of  the  bond  and  mortgage 
in  the  different  states  which  may  not  be  covered  in  all  their 
details  by  the  description  given  above,  but  the  essential  char- 
acteristics of  these  bonds  and  mortgages  are  the  same  in  all 
cases. 

The  bond  and  mortgage  is  used  ordinarily  for  relatively 
small  amounts.  It  is  the  favorite  form  under  which  in- 
dividuals who  own  farms,  city  real  estate,  and  other  property, 

131 


132 


CAPITAL 


raise  long-term  loans  secured  by  this  property.  It  is  fre- 
quently used  also  by  smaller  partnerships  and  corporations. 
But  there  are,  of  course,  some  obvious  drawbacks  to  this  form. 
In  the  first  place,  it  is  necessary  for  the  mortgagor  to  find 
some  one  who  is  willing  to  invest  the  whole  amount  named  in 
the  bond  in  a  lump  sum.  This  may  not  be  difficult  so  long 
as  the  sum  is  small.  Mortgages  are  very  commonly  taken  by 
savings  banks  and  other  institutions  as  well  as  by  individuals 
who  reside  in  the  neighborhood  of  the  property  mortgaged 
and  therefore  are  acquainted  with  it  and  at  the  same  time 
are  able  and  willing  to  advance  the  sum  of  money  that  is 
required.  Within  recent  years  there  has  been  a  concerted  and 
successful  effort  to  extend  the  market  for  farm  mortgages, 
and  a  number  of  brokers  operating  in  the  agricultural  states 
west  of  the  Mississippi  have  built  up  successful  businesses  in 
selling  mortgages  direct  to  investors  in  the  eastern  states. 
Nevertheless  the  limitations  make  this  a  relatively  inefficient 
and  uneconomical  method  of  raising  funds.* 

The  mortgagor  of  a  piece  of  property  may  wish  to  borrow, 
let  us  say,  $20,000.     He  finds  three  men,  one  of  whom  could 
lend  $10,000,  one  $8,000,  and  the  third,  $2,000,  but  no  one 
who  is  in  position  to  lend  $20,000.     All  insist  on  being  pro- 
tected by  a  first  mortgage.    How  is  the  difficulty  to  be  solved?! 
The  answer  is  to  be  found  in  separating  the  bond  and  the] 
mortgage.     Let  the  mortgage  be  drawn  in  favor  of  some  dis-. 
interested  party  who  will  hold  it,  as  trustee,  for  the  lenders] 
of  the  money.     Let  a  bond,  or  promise  to  repay  the  sum  ad- 
vanced, be  given  to  each  lender,  the  bond  to  be  secured  by] 
the  claim  on  the  property  which  has  been  given  to  the  trustee. 
By  separating  the  bond  and  mortgage  we  have  made  it  pos- 


*In  most  other  countries  where  agriculture  is  highly  developed  there  are] 
"mortgage  banks"  which  make  it  their  business  to  receive  and  hold  in  trust  mortgages! 
of  farm  land  and  to  issue  their  own  bonds  based  upon  these  mortgages.  It  is  thus] 
possible  to  secure  for  farmers  the  same  advantages  that  are  treated  in  the  next  para- 
graph and  that  are  now  secured  in  the  United  States  almost  solely  by  large  cor- 
porations. 


BORROWED   CAPITAL— LONG-TERM 


133 


sible  to  secure  the  money  that  is  needed  from  any  number 
of  different  sources  and  yet  have  given  the  same  protection  to 
each  lender  that  would  be  obtained  by  an  individual  who  might 
advance  the  whole  sum  in  a  lump. 

Several  years  ago,  for  example,  John  Wanamaker,  who 
was  at  that  time  individually  the  owner  of  his  Philadelphia 
store,  wished  to  borrow  $10,000,000.  It  would  have  been  a 
difficult  thing  to  find  one  man  or  one  institution  that  was 
willing  to  lend  $10,000,000,  but  it  was  not  especially  difficult 
to  give  one  mortgage  for  this  sum,  to  issue  10,000  bonds  each 
for  $1,000,  all  equally  secured  by  the  mortgage,  and  to  sell 
the  bonds  to  investors.  It  is  in  this  manner  that  the  mortgage 
bond  issues  of  corporations  are  created. 

Corporate  Deeds  of  Trust 

The  mortgage,  separated  from  the  bond,  Is  more  commonly 
known  as  a  "deed  of  trust."  In  ordinary  practice,  the  trustee 
who  holds  title  to  the  property  mortgaged  and  is  supposed  to 
act  on  behalf  of  the  bondholders  is  a  trust  company.  Or- 
dinarily, the  trust  company,  however,  is  actually  chosen,  not 
by  the  bondholders,  but  by  the  corporation  which  issues  the 
bonds.  It  is  always  expected  at  the  outset  that  its  duties  will 
be  of  a  purely  formal  character,  and  in  the  comparatively  rare 
instances  where  it  has  been  necessary  for  the  trustee  to  take 
some  active  steps  in  order  to  protect  the  interests  of  the 
bondholders,  there  has  been  considerable  complaint  that  its 
duties  as  a  trustee  were  not  performed  with  sufficient  vigor. 
It  would  seem  that  some  effective  remedy  for  this  complaint 
ought,  if  possible,  to  be  found.  The  investment  bankers  of 
the  country  who  have  a  moral  responsibility  in  the  matter,  in 
that  they  sell  corporate  bonds  in  large  quantities  to  the  general 
public,  might  well  consider  the  advisability  of  using  their 
powerful  influence  to  insure  closer  vigilance  on  the  part  of  the 
trustees  of  large  corporate  mortgages. 


tu 


CAPITAL 


The  deed  of  trust  for  important  bond  issues  is  apt  to  be  an 
extremely  complicated  and  detailed  document.  To  the  lay 
reader  its  phrasing — like  the  phrasing  of  many  other  legal 
documents — appears  cumbersome  and  unnecessarily  redun- 
dant; but  it  must  be  borne  in  mind  that  thousands  of  cases 
have  been  adjudicated,  each  one  of  which  has  helped  to  inter- 
pret the  exact  shade  of  meaning  of  certain  combinations  of 
words.  After  the  interpretation  has  once  been  made,  it  is 
safer  by  far  to  use  that  combination  of  words  in  the  future, 
rather  than  to  introduce  new  difficulties.  As  the  result  of  long 
experience,  corporate  deeds  of  trust  now  tend  to  follow  cus- 
tomary models  and  usually  contain  practically  the  following 
information: 

1.  A  preamble  which  sets  forth  the  legal  status  of  the 

corporation;  the  amount  of  the  bond  issue  and  also 
of  its  other  bond  issues ;  the  authority  given  by  the 
stockholders  and  directors  for  granting  the  mort- 
gage; the  full  text  of  the  bond  and  other  similar 
information. 

2.  The  granting  clause  which  transfers  the  property  to 

the  trustee ;  describes  the  duties  of  the  trustee ;  and 
contains  the  covenant  of  the  corporation  to  pay 
principal  and  interest  on  the  bond  issue  as  due. 

3.  The  obligation  of  the  corporation  to  maintain  the 

property  in  good  condition;  to  keep  it  insured;  to 
pay  taxes  and  the  like. 

4.  The  procedure   of   the  trustee   in   case   of   default. 

Usually  there  is  no  technical  default  until  30  days 
or  more  after  a  payment  has  become  due.     The 
percentage  of  bondholders — usually  20  to  25% — j 
at  whose  request  the  trustee  shall  proceed  to  fore- 
close the  mortgage  or  to  take  such  steps  as  may  bej 
prescribed. 


BORROWED   CAPITAL— LONG-TERM 


135 


5.  The  responsibilities,  liabilities,  and  compensation  of 
the  trustee  are  presented,  and  provision  is  made  for 
the  resignation  or  removal  of  a  trustee,  and  for  the 
appointment  of  a  successor. 

Many  corporate  mortgages  contain  what  is  known  as  the 
"after  acquired  property"  clause,  which  makes  the  mortgage  ' 
cover  not  only  the  specific  pieces  of  property  described  therein, 
but  also  such  other  property  as  may  later  be  acquired.  The 
object  clearly  is  to  furnish  further  protection  to  the  bond- 
holders and  to  make  it  difficult  for  the  corporation  to  embark 
upon  new  expenditures  without  giving  full  protection  to  the 
bondholders.  When  this  clause  is  missing,  there  is  always 
the  possible  danger  that  the  property  covered  by  the  mortgage 
may  deteriorate  or  at  least  become  of  secondary  importance  as 
compared  with  other  property  later  acquired.  Suppose,  for 
instance,  that  a  manufacturing  corporation  mortgages  one  of 
its  plants  but  later  purchases  another  plant  which  is  better 
located ;  in  that  case  the  first  plant  would  probably  be  neglected 
and  would  rapidly  deteriorate. 

There  is  the  opposite  danger  to  the  corporation  in  case 
the  ''after  acquired  property"  clause  is  included  in  the  mort- 
gage. The  company  may  later  wish  to  purchase  property 
essential  to  its  business  and  which  will  tend  to  increase  the 
value  of  the  property  mortgaged.  In  order  to  purchase  the 
new  property,  it  will  need  to  borrow  more  funds.  But  the 
"after  acquired  property"  clause  covers  the  new  property  with 
a  first  lien  so  that  it  may  be  impracticable  to  use  it  as  security 
for  the  new  loan.  The  usual  solution  of  this  particular  prob- 
lem seems  to  be  to  evade  the  provisions  of  the  mortgage  by 
turning  over  the  newly  acquired  property  to  a  subsidiary  cor- 
poration which  is  then  able  to  give  a  first  mortgage  and  go 
ahead  with  whatever  borrowing  is  required. 

The  question  as  to  whether  to  include  the  "after  acquired 


136 


CAPITAL 


property"  clause  or  not,  is  clearly  a  choice  between  evils.  There 
is  no  universal  answer.  The  circumstances  and  probabilities 
in  each  case  must  be  considered.  This  is  a  problem  that  would 
be  more  easily  solved  if  the  trustees  of  corporate  mortgages 
were  willing  to  assume  a  greater  responsibility,  in  which  case 
the  bondholders  would  doubtless  be  willing  to  leave  them  a 
considerable  amount  of  discretion. 

Another  question  in  connection  with  most  corporate  mort- 
gages and  bond  issues,  is  whether  they  shall  be  ''closed"  or 
"open."  They  are  "closed"  when  a  given  amount  of  bonds 
is  at  once  issued  under  the  mortgage,  but  no  more  may  later 
be  issued.  The  "open"  mortgage,  which  is  not  customary 
except  with  railroad  companies,  leaves  the  total  amount  in- 
definite, although  some  restrictions  are  imposed.  The  most 
common  arrangement  is  to  permit  the  issue  of  bonds  at  a 
fixed  rate  per  mile  of  track.  The  "closed"  mortgage,  like  the 
"after  acquired  property"  clause,  may  prove  a  serious  hin- 
drance to  the  financing  of  new  purchases  which  may  be  in  every 
respect  desirable.  The  "open"  mortgage  is  subject  to  obvious 
abuses.  In  the  practice  of  railroad  corporations,  a  compromise 
has  been  found  in  recent  years  through  the  creation  of  what 
is  known  as  "limited  ojpen  end"  mortgages,  which  authorize 
the  ultimate  issue  of  a  much  larger  amount  of  bonds  than  it  is 
intended  to  issue  immediately.  In  this  way,  the  future  is 
provided  for  to  a  reasonable  extent  and  yet  the  bondholders 
are  protected  from  a  reckless  overissue  which  would  danger^ 
ously  reduce  the  margin  of  safety  back  of  their  holdings. 

These  "limited  open  end"  mortgages  may  even  cover  bondj 
all  of  one  issue  but  bearing  different  rates  of  interest.  This 
has  been  the  case  with  a  number  of  railroad  mortgage  issues. 
Both  the  Chicago  and  Northwestern  Railroad,  and  the 
Chicago,  Milwaukee  and  St.  Paul  Railroad,  have  general  mort-^ 
gages  protecting  some  bonds  that  bear  3^%  and  others  thai 
bear  4%  interest. 


BORROWED   CAPITAL-LONG-TERM  1 37 

Corporate  Bonds 

The  larger  an  issue  of  corporate  bonds — assuming  of 
course  that  it  is  well  secured — the  greater  will  be  the  market- 
ability, and  consequently  the  value  of  each  bond.  It  is  clear 
that  a  local  corporation  which  puts  out,  let  us  say,  one  hundred 
$1,000  bonds,  will  be  able  to  sell  them  only  in  its  local  market. 
The  issue  is  too  small  either  to  become  well  known  or  to  be 
easily  salable  at  a  moment's  notice.  The  big  bond  issues,  on 
the  other  hand,  are  being  traded  in  all  the  time.  It  is  for  this 
reason  that  the  tendency  has  been  strong  in  the  United  States 
toward  consolidating  the  various  bond  issues  of  the  larger 
corporations  into  one  issue,  under  a  so-called  "blanket"  mort- 
gage, thus  securing  the  important  advantages  of  simplicity  and 
of  ready  salability.  $100,000,000  bond  issues,  which  a  few 
years  ago  were  rare,  are  no  longer  regarded  as  uncommon. 
There  are  a  number  of  much  larger  issues,  the  biggest  of  all 
being  the  recently  authorized  issue,  amounting  to  $750,000,- 
000,  of  the  Northern  Pacific  Railroad  Company. 

In  England  this  tendency  toward  large  single  issues  is  not 
nearly  so  apparent.  On  the  contrary,  English  practice  seems 
strongly  to  favor  *''hand  to  mouth"  financing.  Whenever 
money  is  needed,  a  separate  security  is  planned  and  issued 
without  much  reference  either  to  previous  security  issues  or 
to  the  future.  The  result  is  that  many  of  the  English  com- 
panies have  a  complex  series  of  small  bond  issues,  the  relative 
claims  and  value  of  which  call  be  determined  only  after  com- 
petent study.  The  basic  reason  is  doubtless  to  be  found  in 
the  fact  that  the  English  investing  public  is  more  accustomed 
to  buying  and  holding  securities  until  their  maturity  so  that 
there  is  relatively  less  trading  in  the  open  market  than  in  this 
country. 

The  great  majority  of  bonds  in  the  United  States  are  in 

Ienomination  of  $1,000,  although  $500  is  not  uncommon.    In 
r— 


138 


CAPITAL 


toward  the  so-called  *'baby"  bonds  of  $ioo  denomination. 
The  chief  argument  for  these  bonds  is  that  they  make  it  pos- 
sible for  a  small  investor,  with  perhaps  only  $i,ooo  to  $5,000 
available,  to  diversify  his  investment  just  as  is  commonly 
done  by  large  investors.  This  is  an  important  benefit  where 
its  effect  obviously  is  to  reduce  considerably  the  risk  of  heavy 
loss.  The  disadvantage  lies  in  the  increased  cost  of  selling. 
It  costs  practically  as  much  for  a  banker  to  sell  a  $100  bond 
as  to  sell  a  $1,000  bond,  and  his  clerical  expenses  in  connection 
with  the  transaction  are  fully  as  great.  Unless  he  is  operating 
on  a  larger  margin  of  profit  he  does  not  find  the  small  bond 
business  very  attractive. 

Bonds  are  frequently  expressed  in  a  currency  different 
from  that  of  the  country  in  which  they  are  issued.  There  are 
a  great  many  Canadian  bonds,  for  example,  that  are  payable 
in  pounds  sterling,  with  a  view  to  facilitating  their  sale  in 
the  London  market.  The  Pennsylvania  Railroad  Company, 
the  New  York  Central  and  Hudson  River  Railroad  Company, 
and  others,  have  issues  that  are  payable  in  francs  as  well  as 
in  sterling.  The  Brazil  Railways  Company,  an  American 
corporation  operating  in  South  America,  has  a  curious  medley 
of  issues  payable  in  milreis  (Brazilian  currency),  francs, 
pounds  sterling,  and  dollars.  Before  the  European  War,  a 
stronger  and  stronger  tendency  had  been  evident  toward  mak- 
ing the  larger  and  more  important  issues  international,  and 
providing  for  their  payment  at  fixed  rates  of  exchange  in  the 
currency  of  any  of  the  larger  commercial  countries,  at  the 
option  of  the  holder.  It  is  clear  that  this  tendency  has  been 
checked. 

A  great  many  bonds,  especially  those  of  an  international 
character,  are  specifically  payable  in  gold  coin.  This  is  a 
highly  important  provision  in  the  countries  in  which  there  is 
fluctuation,  or  any  considerable  danger  of  fluctuation,  in  thej 
value  of  the  national  currency.     The  European  War,  for  in- 


BORROWED  CAPITAL-LONG-TERM  139 

stance,  caused  a  sudden  drop  m  the  value  of  the  currencies 
of  Brazil,  Chile,  and  other  South  American  countries,  which 
inflicted  serious  loss  on  many  holders  of  securities  payable 
in  national  currency.  On  the  other  hand,  corporations  suf- 
fered serious  loss  if  they  were  unable  to  increase  their  receipts 
in  national  currency  but  at  the  same  time  had  to  pay  their 
obligations  in  gold.  This  was  one  direct  cause  of  the  bank- 
ruptcy of  some  large  enterprises.  During  the  period  of  free 
silver  agitation  in  the  United  States,  prior  to  1896,  bonds 
w^hich  included  the  so-called  "gold"  clause,  sold  at  a  con- 
siderably better  rate  than  those  which  were  payable  In  Ameri- 
can currency,  the  value  of  which  it  was  feared  might  de- 
preciate. 

The  life  of  bond  issues  naturally  varies  a  great  deal,  de- 
pending upon  the  prominence  of  the  business  and  the  nature 
of  the  assets  offered  as  security.  We  shall  have  occasion  to 
discuss  this  question  with  more  detail  in  connection  with  the 
subject  of  methods  of  redemption  of  bonds.  Some  issues  are 
perpetual.  Among  railroads,  100-year  bonds  have  been  fairly 
popular  issues.  Among  those  now  outstanding  which  were 
put  out  for  this  period,  are  Lake  Shore  and  Michigan  first 
3j^'s,  issued  in  1897;  Norfolk  and  Western  first  consolidated 
4's,  issued  in  1896;  Union  Pacific,  first  and  refunding  4's, 
issued  in  1908;  Manhattan  Railway  Elevated  4's,  issued  in 
1890;  and  Reading  divisional  mortgage  issue  of  1897.  The 
Northern  Pacific  has  one  mortgage  for  10 1  and  another  for 
150  years;  the  Erie  Railroad  has  two  mortgages  at  91  years 
and  one  at  84  years. 

Interest  is  almost  always  paid  semiannually.  The  favorite 
dates  are  probably  January  and  July,  although  payments  are 
scattered  through  the  year.  On  account  of  the  tendency  which 
exists  toward  reinvesting  interest  and  dividend  disbursements 
In  January  and  June,  and  the  consequent  tendency  to  Increase 
stock-market  prices  at  this  time,  there  Is  theoretically  a  slight 


140 


CAPITAL 


advantage  to  the  bondholder  in  getting  his  interest  payments 
at  other  periods.  This  can  hardly  be  called  a  consideration  of 
much  practical  weight. 

We  have  already  noted  in  speaking  of  stock  certificates 
that  bond  certificates  may  be  either  in  registered  or  coupon 
form.  In  American  practice  some  bond  issues  are  registered 
and  some  are  in  "bearer"  or  coupon  form.  It  is  becoming 
more  and  more  the  custom  with  large  issues  to  give  the  owners 

^  of  bonds  a  choice  between  the  two  forms.  The  registered 
form  has  the  advantage  of  greater  safety  and  the  bearer  form 
the  advantage  of  greater  convenience.  When  the  issuing  cor- 
poration is  located  at  considerable  distance  or  an  international 
market  is  desired,  the  bearer  form  is  likely  to  be  preferred. 

-The  favorite  plan  at  the  present  time  is  to  make  bonds 
registered  as  to  principal  so  that  the  transfer  of  the  bond  is  not 
fully  completed  until  it  is  made  on  the  books  of  the  corpora- 
tion, but  to  attach  coupons  covering  the  interest  payments  so 
that  coupons — which  are  practically  post-dated  checks — may 
be  clipped  and  deposited  as  they  fall  due.  This  has  been 
demonstrated  by  long  experience  to  be  the  simplest  and  most 
satisfactory  method  of  collecting  interest  payments. 

It  has  been  assumed  so  far  in  this  chapter  that  bonds  are 

'  always  ^secured  by  mortgages  covering  real  property.  This 
is  not,  however,  the  case.     There  are  three  other  important 

,   types  of  security:  first;  bonds,  shares,  or  other  securities  may 

1  be  posted  as  collateral ;  second,^  a  lien  on  chattel  property  such 
as  locomotives,  rolling  stock,  and  the  like  may  be  accepted  as 
security;  third,  the  general  credit  of  a  corporation  may  be  the 
only  security. 

\  We  shall  see  plainly,  in  reviewing  these  various  types  of{ 

securities  and  their  variations,  that  it  is  unsafe  to  place  much 
dependence  upon  names.  A  "general  mortgage"  may  not  have 
a  first  lien  upon  anything;  "first  and  refunding"  or  "first  andi 
unifying"  and  the  like  may  indicate  a  first  mortgage  on  some 


BORROWED    CAPITAI^LONG-TERM  I4I 

small  subdivisions  of  the  property  and  a  second,  third,  or 
fourth  mortgage  on  the  rest  of  the  property.  Every  bond 
issue  stands  by  itself  and  has  its  own  peculiarities.  It  is  un- 
safe to  comment  upon  it — and  it  is  certainly  unsafe  in  the 
extreme  to  buy  it — without  having  first  studied -with  some 
care  the  exact  terms  and  extent  of  its  claim  upon  property  and 
the  nature  and  value  of  the  property  itself. 

Mortgage  Bonds 

Bonds  that  are  backed  by  a  mortgage  on  real  property  are, 
in  this  country,  the  most  popular  type  of  bonds  and  will 
probably  always  remain  so.  In  the  United  Kingdom  it  is 
customary  to  issue  debenture  bonds  (having  no  specific  secur- 
ity behind  them)  in  many  cases  where  we  issue  mortgage 
bonds.  The  difference  is  in  name  rather  than  in  fact,  for 
the  English  debenture  bonds  are  considered  by  the  investor 
with  at  least  partial  reference  to  the  amount  and  the  nature  of 
the  corporation's  holdings  of  real  property. 

After  all,  the  great  bulk  of  the  wealth  of  this  country  is 
in  the  form  of  real  estate.  The  greater  the  increase  of  other 
forms  of  wealth,  the  greater  must  be,  necessarily,  the  increase 
in  land  values.  Hence,  a  mortgage  on  land,  assuming  that  it 
is  conservatively  placed,  is  bound  to  remain  the  most  common 
and  perhaps  the  safest  form  of  security.  This  is  not  to  say, 
by  any  means,  that  every  mortgage  bond  is  safe,  but  only  to  v^ 
state  the  general  principle  that  land  and  other  real  property 
constitute  the  most  acceptable  form  of  security  for  bond 
issues. 

Not  only  is  a  promise  to  pay  secured  by  real  estate  the 
most  popular  type  of  secured  obligation,  but,  for  most  in- 
dividually owned  businesses,  partnerships,  and  small  corpora- 
tions, it  is  in  fact  the  only  practical  form  of  long-term  obliga- 
tion. Other  forms  of  security  are  utilized  in  the  main  only 
by  large  concerns  which  are  widely  and  favorably  known  and 


142  CAPITAL 

therefore  enjoy  an  exceptional  measure  of  credit  apart  from 
their  property  holdings. 

The  great  mass  of  obligations  on  real  property  are  secured 
by  first  mortgages.  There  is  a  considerable  amount,  also,  of 
second  mortgage  securities  and  relatively  few  third  and  fourth 
mortgage  securities.  Third  and  fourth  mortgages  are  seldom 
found  except  among  the  obligations  of  large  railroad  corpora- 
tions. The  Northern  Pacific  put  out  a  third  mortgage  issue 
of  $12,000,000  in  1887;  the  Erie  Railroad  has  outstanding 
third,  fourth,  and  fifth  mortgage  bonds.  Modern  practice 
favors  disguising  these  junior  issues  by  some  euphemistic 
and  suggestive  title.  For  instance,  in  the  financing  of  the 
Erie  Railroad  when  a  sixth  mortgage  issue  was  found  to  be 
necessary,  it  was  not  called  a  "sixth  mortgage"  but  "Erie 
Railroad  First  Consolidated  Mortgage  7's,  1920."  This  title 
does  not  mean,  as  the  unsophisticated  might  imagine,  that  the 
issue  is  protected  by  a  first  mortgage,  but  only  by  a  "first  con- 
solidated mortgage"  whatever  that  may  be.  A  little  later  we 
have  the  "First  Consolidated  4's,  1996,"  which  receive  the 
title  of  "first"  apparently  because,  though  not  the  first  con- 
solidated issue  of  the  road,  they  are  the  first  consolidated  issue 
to  bear  interest  at  the  rate  of  4%.  Finally,  the  Erie  put  out 
what  is  practically  an  eighth  mortgage,  which  was  christened 
"General  Mortgage  Convertible  4's,  1953."* 

The  Erie  is  a  shining,  but  by  no  means  isolated,  example. 
It  would  not  be  difficult  to  bring  to  light  many  another  fourth, 
fifth,  sixth,  or  even  later  mortgage  which  is  masquerading  as  a 
"first  refunding"  or  "prior  lien"  or  under  some  other  high- 
sounding  name. 

A  second  mortgage  issue,  when  it  is  recognized  as  such, 
will  customarily  have  to  pay  a  rate  of  interest  J4  to  1%  higher 
than  a  first  mortgage  issue,  and  will  customarily,  also,  be 
redeemable  within  a  shorter  period.     The  issues  which  are 

•See  W.   H.   Lyon's  "Capitalization,"  pp.   n8-121. 


BORROWED   CAPITAL— LONG-TERM  143 

protected  by  subsequent  mortgages  may  be  expected  ordinarily 
to  pay  still  higher  interest  rates  in  rough  proportion  to  the 
priority  of  their  claims.  However,  this  is  not  stated  as  an 
invariable  rule,  for  in  many  cases  the  junior  mortgage  issues 
are  of  larger  size  and  enjoy  a  wider  market  or  have  the  other 
advantages  which  more  than  compensate  for  the  inferiority 
of  their  liens. 

Ratio  of  Mortgage  to  Value 

The  question  as  to  the  correct  percentage  of  obligations 
secured  by  mortgage  to  the  appraised  value  of  the  mortgaged 
property  is  one  of  much  practical  interest.  There  are  many 
surprising  variations  in  practice.  Roughly  speaking,  it  may 
be  said  that  the  highest  grade  issues,  secured  by  a  mortgage  on 
land,  do  not  exceed  50  to  60%  of  the  appraised  value  of  the 
land.  The  highly  regarded  "cedulas,"  for  example,  issued  by 
the  National  Mortgage  Bank  of  the  Argentine  Republic,  never 
exceed  50%  of  the  appraised  value  of  the  mortgaged  land. 
In  ordinary  practice,  a  second  mortgage  on  land  should  not 
bring  the  total  mortgage  issues  above  80%  of  its  value.  A 
mortgage  based  in  part  on  buildings  and  other  improvements 
which  may  not  be  easily  adapted  to  other  uses,  and  are  not  so 
readily  salable  as  land  alone,  cannot  safely  run  to  as  high  a 
percentage  of  the  appraised  value. 

The  percentages  that  have  just  been  given  are  intended  to 
represent  an  ideal — or  at  any  rate,  the  most  exacting  standards 
— rather  than  ordinary  commercial  practice.  The  following 
examples  picked  at  random  from  the  reports  of  many  different 
companies  operating  in  various  fields  and  carrying  on  various 
kinds  of  business,  show  provisions  that  have  been  found  ac- 
ceptable by  some  of  the  good  banking  houses: 

The  Montreal  Light,  Heat  and  Power  Company  has  per- 
mission to  issue  4j/^%  first  mortgage  bonds,  to  pay  for  im- 
provement up  to  75%  of  the  cost  of  the  improvements. 


144 


CAPITAL 


The  Mississippi  River  Power  Company  can  issue  bonds  in 
excess  of  $16,000,000  under  its  first  mortgage,  up  to  80%  of 
the  cost  of  improvements. 

The  Powell  River  Company,  which  produces  water-power, 
manufactures  paper,  etc.,  can  issue  additional  bonds  under 
its  first  mortgage  up  to  not  more  than  50%  of  the  actual  cost 
of  permanent  extensions,  additions,  improvements,  or  ac- 
quisitions. 

The  Steel  Company  of  Canada,  Ltd.,  may  issue  additional 
bonds  to  the  extent  of  66  2/3%  of  the  proposed  value  of  new 
fixed  assets. 

The  Taylor- Wharton  Iron  and  Steel  Company  may  issue 
its  first  mortgage  5's  beyond  $1,250,000  for  permanent  im- 
provements up  to  75%  of  their  cost. 

The  American  Ice  Company  may  issue  the  balance  of  its 
real  estate  first  and  general  sinking  fund  gold  6's,  for  improve- 
ments up  to  75%  of  the  cost. 

The  United  States  Lumber  and  Cotton  Company  can  issue 
additional  bonds  to  the  extent  of  50%  of  the  cost  of  better- 
ments. 

The  American  Sales  Book  Company,  Ltd.,  may  put  out 
the  balance  of  its  first  sinking  fund  6's,  up  to  80%  of  the 
cost  of  extensions. 

Both  the  New  York  and  Cuba  Mail  Steamship  Company 
and  the  New  York  and  Porto  Rico  Steamship  Company  are 
permitted  to  issue  additional  first  5's  for  80%  of  the  actual 
cost  of  new  property. 

The  General  Baking  Company,  incorporated  in  191 1,  a 
combination  of  twenty  large  baking  establishments  in  various 
large  eastern  cities,  is  permitted  to  issue  the  balance  of  its 
authorized  first  mortgage  bonds  to  the  extent  of  70%  of  the 
cost  of  permanent  betterments,  improvements,  developments, 
extensions,  and  additions,  except  for  the  purchase  of  stocks 
of  other  companies. 


BORROWED   CAPITAL— LONG-TERM 


145 


The  General  Pipe  Line  Company  may  issue  bonds  to  pro- 
vide 80%  of  the  actual  cost  of  acquisitions,  additions,  etc. 

The  International  Milling  Company  of  Minnesota  may 
issue  bonds  up  to  75%  of  the  actual  cost  of  the  establishment 
of  additional  mills. 

The  Iroquois  Iron  Company  may  issue  first  gold  5's  up  to 
60%  of  the  cost  of  additions  and  extensions. 

The  Chicago  Bell  Telephone  Company  restricts  its  first 
mortgage  issue  to  50%  of  the  value  of  its  property  or  60% 
of  the  value  of  its  real  estate;  it  may  issue  further  bonds  not 
to  exceed  75%  of  the  cost  of  additional  improvements  and 
extensions. 

The  Nashville  Railway  and  Light  Company  may  issue  its 
authorized  bonds  up  to  80%  of  the  cost  of  improvements. 

In  general,  manufacturing  companies  are  supposed  to  pre- 
serve a  margin  of  safety  of  at  least  25%  between  the  cost 
of  improvements  and  the  amount  of  bonds  issued  to  finance 
these  improvements.  This  margin  may  be  reduced  to  20% 
in  the  case  of  companies  that  have  a  very  stable  business,  or 
may  be  increased  to  as  much  as  40  or  50%  for  companies  that 
do  not  claim  any  especial  degree  of  stability  in  their  earnings. 

Equipment  Trust  Bonds 

When  a  dealer  sells  a  piano  on  the  instalment  plan,  he 
does  not  ordinarily  give  his  customer  at  once  full  title  to  the 
piano;  instead  he  "leases"  it  at  a  rental  equal  to  the  amount 
of  the  instalment  payments  agreed  upon,  with  a  further  agree- 
i  ment  that  as  soon  as  the  payments  under  the  lease  equal  the 
agreed  price  for  the  piano,  then  these  payments  shall  cease  and 
full  title  shall  pass  to  the  customer.  By  this  simple  device  he 
protects  himself  in  part  against  an  unscrupulous  purchaser 
who  might,  if  he  had  full  title,  dispose  of  the  piano,  spend 
the  cash  that  he  received  in  payment,  and  leave  the  dealer  only 
the  doubtful  privilege  of  suing  him  for  fulfilment  of  his  con- 


146 


CAPITAL 


tract.  Under  the  "lease"  arrangement,  the  customer  has  no 
right  to  resell  the  piano  until  his  own  payments  have  been 
fully  completed.  It  is,  of  course,  recognized  that  a  "lease" 
of  this  kind  is  essentially  a  legal  fiction — just  as  the  mortgage 
which  conveys  the  title  to  the  lender  of  money  is  a  legal  fic- 
tion. Nevertheless  it  is  a  fiction  which  is  useful  and  indeed 
indispensable. 

When  a  manufacturer  of  railroad  equipment  sells  an  order 
of  millions  of  dollars'  worth  of  cars  or  locomotives  to  a  rail- 
road, he  protects  himself  in  the  same  way.  The  title  is  retained 
in  his  own  hands ;  the  railroad  merely  "leases"  the  rolling  stock 
with  an  agreement  that  on  completion  of  the  payment  of  a 
certain  amount,  the  "lease"  shall  become  inoperative  and  the 
title  will  be  taken  by  the  railroad.  Thus  the  railroad  com- 
pany— just  like  the  individual  who  buys  his  piano  on  the  in- 
stalment plan — is  unable  to  dispose  of  the  cars.  A  point  of 
greater  practical  importance  is  that,  in  case  of  receivership 
or  financial  embarrassment,  the  seller  of  the  cars  or  locomo- 
tives can  take  them  back  if  he  chooses;  they  belong  to  him, 
not  to  the  railroad. 

There  are  some  variations  of  this  procedure  but  they  do 
not  affect  its  principle.  The  chief  variation  consists  in  the 
introduction  of  a  financing  company  between  the  manufacturer 
of  railroad  equipment  and  the  railroad  company  which  pur- 
chases the  equipment.  The  financing  company  takes  upon 
itself  the  burden  of  paying  the  manufacturer,  and  receives  title 
to  the  cars  or  locomotives.  This  title  it  may  offer  as  security 
for  an  issue  of  equipment  trust  obligations  in  the  form  of  bonds 
or  notes.* 

Equipment  bonds  enjoy  an  excellent  reputation  for  safety; 
in  fact,  it  is  claimed  that  there  has  been  no  default  on  them 
since  they  have  been  in  use.     Even  though  a  railroad  may  go 


*These  equipment  trust  obligations  may  be  called  either  bonds  or  notes  almost 
indiscriminately;  as  they  generally  run  for  10  or  15  years,  it  is  perhaps  a  little  better 
to  speak  of  them   as   "bonds." 


BORROWED   CAPITAI^LONG-TERM 


147 


into  receivers'  hands  and  become  almost  a  total  financial  wreck, 
it  cannot  afford  under  any  conditions  to  give  up  its  rolling 
stock,  and  must  therefore  maintain  its  annual  payments.  Foi 
this  reason  it  happens  that  the  equipment  trust  bonds,  even 
of  railroads  that  are  actually  in  receivership  and  that  have 
defaulted  on  practically  all  of  their  other  obligations,  fre- 
quently sell  on  a  basis  of  5  to  6j^%.  The  equipment  trust 
bonds  of  sound  railroad  corporations  are  in  great  demand 
and  sell  customarily  on  a  basis  of  4  to  5%. 

It  has  been  at  times  suggested  that  the  same  principle 
might  be  more  widely  applied,  as  for  instance  in  selling  ma- 
chinery and  other  essential  equipment  to  manufacturing  cor- 
porations. The  difficulty,  however,  arises  that  outside  the  rail- 
road field,  transactions  which  could  be  financed  by  equipment 
trust  obligations  are  of  comparatively  small  size,  and  could 
not  easily  be  standardized  in  such  a  way  as  to  make  them 
appeal  to  the  investing  public.  The  average  investor,  even 
though  he  may  be  a  bank  official  and  well  acquainted  with 
financial  practice,  does  not  care  to  spend  much  time  in  analyz- 
ing and  investigating  propositions  that  are  put  up  to  him  when 
he  goes  into  the  market  to  buy  a  security.  He  wants  to  get 
something  that  is  standardized  and  familiar.  It  is  only  after 
years  of  active  effort  that  a  new  financial  method  ordinarily 
can  be  introduced.  For  this  very  reason  there  is,  perhaps,  a 
real  opportunity  which  some  one  will  sooner  or  later  seize,  to 
apply  the  equipment  trust  method  more  widely  and  thus 
facilitate  the  sale  of  many  kinds  of  machinery. 

Collateral  Trust  Bonds 

The  use  of  marketable  stocks  and  bonds  as  collateral  for 
short-time  loans  has  already  been  noticed  in  the  chapter  pre- 
ceding. The  issue  of  long-term  obligations  based  on  similar 
security  is,  however,  comparatively  a  modern  invention.  There 
is  a  fundamental  distinction  between  the  two. 


148 


CAPITAL 


Short-term  obligations  are  ordinarily  secured  by  stocks 
and  bonds  which  are  active  and  which  the  borrower  holds 
temporarily  for  resale.  Long-term  bonds  should  never  be 
secured  except  by  stocks  and  bonds  that  it  is  intended  to  hold 
permanently.  Ordinarily  these  securities,  posted  as  collateral, 
are  those  of  subsidiary  corporations  or  of  other  corporations 
in  which  the  borrowing  company  expects  to  maintain  a  per- 
manent interest.  Sometimes  nearly  all  the  stocks  and  bonds 
of  subsidiary  companies,  held  in  the  treasury  of  the  parent  J 
company,  are  collected  and  posted  in  one  lot.  This  is  the 
case,  for  instance,  with  the  Missouri  Pacific  $10,000,000  issue 
of  collateral  trust  bonds  which  is  secured  by  the  deposit  of 
first  mortgage  bonds  of  subsidiary  companies.  Twenty  of 
these  companies  are  represented,  one  of  which  is  operating  a 
road  only  two  miles  long. 

It  is  a  somewhat  curious  fact  that  a  collateral  trust  issue 
will  generally  sell  at  a  much  better  price  than  will  the  stocks 
and  bonds  which  are  posted  as  collateral.  The  reason  is  to 
be  found  not  only  in  the  fact  that  the  parent  company  is  add- 
ing its  quota  of  credit  to  the  credit  standing  of  its  various! 
subsidiaries,  but  also  in  the  fact  that  the  collateral  trust  issue 
is  comparatively  large  and  therefore  commands  more  atten- 
tion and  a  better  market.  Inasmuch  as  the  amount  and  quality 
of  the  collateral  posted  is  seldom  examined  with  much  care 
by  investors,  there  is  always  a  chance,  unless  the  banking 
syndicate  which  sells  the  issue  is  very  careful,  that  the  col-j 
lateral  will  eventually  be  found  of  less  value  than  was  origin- 
ally supposed.  The  general  public,  in  fact,  has  no  method,! 
ordinarily,  of  securing  genuine  information  as  to  the  status] 
and  prospects  of  subsidiary  companies  whose  securities  an 
posted.  It  must  regretfully  be  admitted  that  the  collateral 
trust  device  has  sometimes  been  used  to  obtain  credit  for  cor- 
porations that  were  not  worthy  of  credit. 

A  collateral  trust  bond  issue  is  the  favorite  method  oj 


BORROWED   CAPITAL-LONG-TERM  1 49 

financing  the  purchase  by  one  corporation  of  the  securities  of 
another  corporation.  The  ptirchase  may  be  made  in  the  first 
place  with  temporary  bank  loans,  which  in  their  turn  are 
repaid  as  soon  as  the  collateral  trust  bonds  can  be  sold  to 
the  investing  public.  It  was  in  this  way,  for  instance,  that 
the  Northern  Pacific  and  Great  Northern  financed  their  pur- 
chase of  stock  of  the  Chicago,  Burlington  and  Ouincy  Rail- 
road Company.  The  collateral  trust  bond  issue  based  upon 
this  stock  is  highly  regarded.  In  the  same  way  the  Atlantic 
Coast  Line  took  care  of  the  purchase  of  Louisville  and  Nash- 
ville stock,  and  the  Union  Pacific  of  the  purchase  of  Southern 
Pacific,  of  Baltimore  and  Ohio  and  of  New  York  Central 
stock. 

While  the  collateral  trust  bond  issue  is  used  most  exten- 
sively by  railroad  corporations,  it  is  common  also  among 
public  utility  holding  companies  and  is  used  to  a  less  extent 
by  industrial  combinations.  The  customary  rule  is  to  make 
the  collateral  trust  bond  issue  about  80%  of  the  appraised 
market  value  of  the  securities  posted  as  collateral.  This  is 
the  same  percentage  that  is  commonly  regarded  as  proper 
among  banks  in  granting  short-term  collateral  loans.  How- 
ever, there  are  some  exceptions.  For  example,  the  Queens- 
boro  Corporation,  which  deals  in  New  York  City  real  estate, 
has  outstanding  an  issue  of  first  gold  4's,  secured  by  a  deposit 
of  mortgages  on  New  York  City  real  estate  to  an  amount  at 
least  equal  to  the  bond  issue. 

Debenture  Bonds 

A  debenture — to  give  its  literal  and  also  its  technical  legal 
meaning — may  be  defined  as  any  acknowledgment  of  debt 
which,  of  course,  implies  a  promise  to  repay  the  debt.  In 
financial  practice,  however,  the  word  has  gradually  become 
restricted  until  it  now  means  only  an  unsecured  promise  to 
repay  a  debt.     In  England  a  distinction  is  made  between  de- 


ISO 


CAPITAL 


benture  bonds,  generally  called  simply  "debentures,"  and  de- 
benture stock ;  debenture  bonds  are  in  fixed  amounts  ( say  £20, 
£100,  £200,  £1,000,  etc.),  while  debenture  stock  may  be  trans- 
ferred in  any  amount  that  may  happen  to  suit  the  convenience 
of  buyer  and  seller.  Under  English  practice  a  man  may  hold 
debenture  stock  in  an  amount,  let  us  say,  of  £1263  6s.  3d.,  and 
may  sell,  let  us  say  £563  4s.  2d. ;  while  of  debenture  bonds 
his  holdings  and  his  sales  must  be  in  fixed  amounts  depending 
on  the  conditions  of  issue.  Thus  it  will  be  seen  that  in  England 
the  distinction  between  debenture  bonds  and  debenture  stock  is 
much  the  same  as  between  ordinary  shares  and  ordinary 
stock. 

The  English  practice  and  American  practice  in  the  use  that 
is  made  of  debentures  is  entirely  different.     In  English  prac- 
tice the  mortgage  bond  is  not  so  nearly  universal  as  in  this 
country,  and  the  debenture  bond  or  stock  takes  its  place.    We 
may  draw  a  loose  distinction  between  the  two  systems  by 
saying  that  the  American  practice  favors  the  issuance  of  obli- 
gations which  are  primarily  protected  as  to  their  principal  by 
the  issuing  company's  assets,  and  as  to  their  interest  claims 
by  the  issuing  company's  income;  while  in  English  practice, 
the  bondholder  is  protected  primarily  as  to  his  interest  by  the 
priority  of  his  claim  on  the  issuing  company's  income,  and  is 
protected  as  to  his  principal  only  by  the  general  credit  ofj 
the  issuing  company.     There  has  been  some  little  debate  atj 
different  times  as  to  the  relative  merits  of  the  two  systems. 
The  American  system  is  criticized  on  the  ground  that,  after] 
all,  the  only  test  of  the  value  of  a  company's  assets  is  the] 
amount  of  income  they  yield,  and  the  English  system,  there- 
fore, is  not  only  simpler  but  more  logical.    On  the  other  hand,] 
it  is  stated  that,  in  case  the  English  debenture  holder  fails  to 
receive  his  interest  payments  regularly,  he  has  no   further] 
claim  on  which  he  can  fall  back.     Hartley  Withers,  a  leading 
English  authority,  asserts  that  "mortgage  rights,  carrying  witl 


BORROWED    CAPITAL— LONG-TERM 


151 


them  the  power  of  foreclosure,  are  always  desirable  to  com- 
plete the  security  of  the  debenture  holder The  absence 

of  mortgage  rights  is  a  weakness  in  an  otherwise  watertight 
security."* 

The  debate  is  of  little  more  than  academic  interest,  for  the 
practice  of  each  country  is  firmly  established  and  is  unlikely 
to  be  changed  by  any  argument. 

In  the  United  States,  debenture  bonds  are  quite  commonly 
used  in  railroad  reorganizations,  in  the  general  scaling  down 
of  claims  upon  the  assets  and  income  of  the  corporation. 
There  will  be  references  to  some  such  cases  in  connection 
with  the  later  study  in  this  volume  of  reorganization  practice. 
In  other  cases,  debentures  have  been  issued  by  American  cor- 
porations in  high  credit,  simply  because  they  preferred  the 
simplicity  of  the  debenture  form,  and  were  able  by  reason  of 
their  general  credit  to  sell  them  on  a  satisfactory  basis.  This 
has  been  true  in  the  past,  particularly  of  the  New  England 
railroads,  the  New  York,  New  Haven  and  Hartford,  and  the 
Boston  and  Maine. 

Still  another  case'  that  calls  for  debenture  bonds  exists 
when  a  small  corporation  which  has  a  relatively  small  amount 
of  tangible  assets,  but  possesses  good- will  and  other  intangible 
assets  of  high  value,  desires  to  make  a  long-term  loan.  Inas- 
much as  a  corporation  of  this  type  does  not  have  the  proper 
basis  for  either  a  mortgage  bond  issue  or  a  collateral  trust 
bond  issue,  it  is  likely  to  fall  back  on  a  debenture  bond  issue. 
This  is  especially  true,  for  example,  of  publishing  companies, 
many  of  which  are  well  established  and  can  conservatively  put 
out  a  long-term  loan  and  yet  possess  tangible  assets  of  com- 
paratively small  and  uncertain  value.  Following  is  a  form  of 
debenture  bond  which  has  recently  been  used  by  a  small  com- 
pany of  this  type,  and  which  is  suitable  for  use  in  similar 
cases: 


•Hartley  Withers   on  "Stocks   and  Shares,"  p.   96. 


52 


CAPITAL 

Twenty-year  Six  Per  Cent  Debenture 

The Company,  a  Corporation  of  the 

State  of  New  York  (hereinafter  called  the  Company)  is 
indebted  and  for  value  received  promises  to  pay  to  the 
registered  holder,  the  sum  of 

One  Thousand  Dollars 
in  lawful  money  of  the  United  States,  on  or  before 
August  15,  1931,  and  interest  semiannually  on  said  sum, 
at  the  office  of  the  Company  in  the  City  of  New  York, 
at  the  rate  of  six  per  cent  per  annum,  on  August  15  and 
February  15  in  each  year.  Such  interest  shall  be  cumu- 
lative and  payable  in  priority  to  any  dividends  on  the 
stock  of  the  Company  for  such  half-yearly  period. 

This  Debenture  is  one  of  a  series  of  47  debentures, 
all  of  even  date,  27  being  for  the  principal  sum  of 
$1,000  each;  three  for  the  principal  sum  of  $500  each; 
13  for  the  principal  sum  of  $100  each,  and  4  for  the  prin- 
cipal sum  of  $50  each,  a  total  of  $30,000. 

This  Debenture  shall  immediately  become  due  and 
payable  if  a  judgment  or  decree  is  rendered  for  the  disso- 
lution of  the  Company  by  any  court  having  jurisdiction 
thereof,  or  if  the  Company  is  adjudicated  a  bankrupt  or 
insolvent,  or  if  an  efifective  resolution  is  passed  by  the 
stockholders  for  the  voluntary  dissolution  of  the 
Company. 

This  Debenture  may  be  redeemed  by  the  Company  at 
any  time  at  its  face  value,  and  interest  earned  and  unpaid 
hereon,  upon  thirty  days'  notice  in  writing  sent  by  mail 
or  delivered  personally  to  the  registered  holder  hereof. 

A  Register  of  the  debentures  shall  be  kept  at  the 
Company's  principal  office  containing  the  names  and 
addresses  of  the  registered  holders  and  particulars  of 
the  debentures  by  them  respectively. 

Every  Transfer  of  this  debenture  must  be  in  writing, 
signed  by  the  registered  holder,  or  his  legal  personal 
representative,  and  shall  be  delivered  at  the  Company's 
principal  office,  and  duly  acknowledged,  if  required  by  the 
Company,  and  thereupon  the  transfer  will  be  registered 
and  a  note  of  such  registration  entered  hereon. 


BORROWED    CAPITAL— LONG-TERM 

In  Witness  Whereof  the  Company  has  caused  this 
instrument  to  be  signed  in  its  name  and  behalf  by  its 
President,  and  its  corporate  seal  to  be  hereunto  affixed 
and  attested  by  its  Secretary,  this  nth  day  of  August, 
1911. 

Company 

By 

President 
Attest : 


153 


Secretary 

It  is  quite  possible  that,  in  many  instances  where  small 
corporations  are  now  borrowing  up  to  the  limit  of  safety 
at  a  bank  and  yet  are  cramped  for  funds,  a  small  issue  of 
debenture  bonds  could  be  marketed  among  people  who  are 
acquainted  with  the  corporation  and  recognize  its  solidity. 

Some  debenture  bonds,  although  not  secured  by  the  pledge 
of  specific  properties,  are  protected  by  especial  provisions 
which  may  give  them  an  advantage  over  holders  of  wholly 
unsecured  and  unprotected  obligations  in  case  of  reorganiza- 
tion. For  instance,  the  American  Cotton  Oil  Company  has 
outstanding  an  issue  of  debenture  bonds  the  principal  of  which 
may  at  once  become  due,  in  case  there  is  a  default  in  payment 
of  interest,  at  the  option  of  a  majority  of  the  holders  of  the 
bonds.  The  American  Tobacco  Company's  gold  debenture 
6's  and  4's  are  not  secured  by  lien  or  mortgage  on  properties, 
but  a  charge  is  imposed  in  favor  of  the  trustees  acting  for 
the  debenture  bondholders,  upon  the  property  and  upon  all 
the  present  and  future  net  incomes  of  the  corporation.  This 
gives  the  owners  of  these  debentures  an  advantage  over  the 
owners  of  any  subsequent  debentures  or  obligations  that  the 
company  may  incur. 

There  are  one  or  two  curious  instances  of  so-called  deben- 
ture bonds  issued  in  this  country  and  in  Canada,  which  are 
not,  in  fact,  debentures  at  all,  but  possess  what  is  here  consid- 


154 


CAPITAL 


ered  a  preferable  mortgage  security.  For  example,  the  Cana- 
dian Niagara  Power  Company  has  outstanding  an  issue  of  6% 
debentures,  series  ''A"  and  '*B"  of  which  are  secured  by  a 
first  mortgage,  and  series  "C"  by  a  second  mortgage.  The  I 
Wabash  Railroad  Company  has  a  third  mortgage  issue  out- 
standing which  is  called  ^'Debenture  Bond  Series  'A.'  "  Some 
of  the  Chicago  and  Great  Western  debentures,  also,  are  really 
mortgage  bonds.  As  has  been  remarked  before,  it  is  unsafe 
to  place  any  reliance  upon  names  unless  they  are  used  in  a  J 
strictly  legal  sense.  The  use  of  the  term  "debenture"  in  all 
these  companies  is  doubtless  in  order  to  facilitate  the  sale  of 
the  bonds  in  the  English  market. 

Income  Bonds 

Income  bonds  may  be  briefly  described  as  almost  the  exact 
opposite  of  debentures.  The  debenture  has  primarily  a  claim 
on  income,  with  little  or  no  specific  security  for  the  repay- 
ment of  the  principal.  The  income  bond  is  usually  secured 
as  to  its  principal  by  a  mortgage  lien  of  some  kind,  but  has 
no  claim  for  interest  payments  except  as  and  when  the  issuing 
corporation  has  a  surplus  of  earnings  over  and  above  all  prior 
claims.  The  income  bond  is  a  hybrid  and  frequently  possesses 
few  of  the  attractive  features  either  of  ordinary  bonds  or 
of  stock.  It  is  seldom  accepted  by  investors  from  choice.  Most 
of  the  issues  of  income  bonds  now  outstanding  are  the 
products  of  reorganization.  In  the  general  scaling  down  of 
creditors'  claims  which  attends  every  successful  reorganization, 
some  of  the  bondholders  are  likely  to  be  required  to  give  up 
their  claim  to  a  fixed  income,  and  to  accept  the  claim  which 
is  possessed  by  the  income  bond  to  a  fixed  income  only  when 
it  is  earned. 

Theoretically,  this  arrangement  is  fair  enough  and  offers 
junior  bondholders  of  an  insolvent  corporation  all  that  they 
can  reasonably  expect  to  obtain.     When  income  bonds  were 


BORROWED   CAPITAI^LONG-TERM 


155 


first  issued  extensively  in  the  United  States,  during  the  numer- 
ous railroad  reorganizations  of  the  8o's,  they  were  generally 
regarded  as  an  ingenious  and  praiseworthy  device,  but  later 
experience  has  not  confirmed  this  favorable  first  impression. 
Difficulties  continually  arise  out  of  the  fact  that  the  determina- 
tion of  net  earnings  in  a  large  corporation  is  not  a  purely 
mathematical  process,  but  involves  much  discretion  and  con- 
tinually gives  rise  to  differences  of  opinion.  It  is  to  the  interest 
of  the  common  stockholders,  who  usually  have  control  of  the 
corporation,  to  defer  payments  to  income  bondholders  as  long 
as  possible,  or  until  the  time  arrives  when  dividends  may  be 
distributed  also  to  the  stockholders.  It  is  easy  enough  for  them 
to  prevent  payment  of  interest  on  income  bonds  if  they  so 
desire,  by  instructing  the  auditor  to  charge  many  expenditures 
of  a  capital  nature  into  operating  expenses,  thus  reducing  the 
nominal  showing  of  net  earnings. 

The  best-known  case  of  this  kind  is  that  of  the  Central  of 
Georgia  Railway  Company,  which  issued  in  its  reorganization 
of  1895,  three  series  of  income  bonds,  all  falling  due  in  1945. 
For  several  years  the  holders  of  income  bonds,  to  whom  no  pay- 
ments were  made,  protested  that  they  were  not  receiving  fair 
treatment.  Finally,  in  19 13,  after  long  litigation,  an  auditor 
was  appointed  by  the  court  and  found  that  the  Ocean  Steam- 
ship Company,  all  of  the  stock  of  which  was  owned  by  the 
Central  of  Georgia  Railway  Company,  had  been  earning  large 
profits  which  were  never  taken  into  the  published  accounts  of 
the  Central  of  Georgia  Railway  Company.  The  earnings  of 
the  Ocean  Steamship  Company  were  turned  over  to  the  parent 
corporation  under  the  fiction  of  a  "loan"  which  was  never  in- 
tended to  be  repaid.  Counsel  for  the  Railway  Company  did 
not  deny  the  facts  but  argued  on  the  strictly  technical  ground 
that  so  long  as  dividends  had  not  been  declared  by  the  directors 
of  the  Ocean  Steamship  Company,  it  was  impossible  to  include 
these  earnings  in  the  income  account  of  the  Central  of  Georgia 


1^6  CAPITAL 

Railway  Company.  It  is  a  relief  to  find  that  the  court  dis- 
regarded this  shallow  pretext  and  took  the  common-sense  view 
that  the  earnings  of  the  Central  of  Georgia  Railway  included 
the  earnings  of  its  subsidiary  company.  In  this  instance  the 
income  bondholders  finally  won  their  case  and  are  now  receiv- 
ing payments  of  interest.  It  was,  however,  a  long  and  hard 
battle  which  offers  little  encouragement  to  investors  to  put 
their  money  into  securities  of  this  type.  It  has  been  well 
remarked  in  this  connection  that  "the  income  bondholder 
may  find  that  he  has  purchased  a  lawsuit  rather  than  a 
security."* 

Sometimes  the  holders  of  income  bonds  are  given  some 
of  the  rights  of  stockholders.  The  income  bondholders  of 
the  New  York  Railways  Company,  which  owns  a  number  of 
the  surface  street  railway  lines  in  New  York  City,  have  the 
right  to  elect  five  out  of  eleven  directors  of  that  company.  In 
the  latter  part  of  19 14,  an  active  campaign  to  secure  the 
proxies  of  income  bondholders  was  conducted  by  the  presi- 
dent of  the  N-ew  York  Life  Insurance  Company,  with  the  co- 
operation of  other  investors.  It  was  announced  that  this  cam- 
paign was  based  on  the  belief  that  the  bonds  were  entitled  to 
more  interest  than  they  had  been  receiving  and  that  it  was 
desired  to  elect  directors  who  took  the  same  view.  "It  shouldj 
be  remembered,"  it  was  stated,  "that  these  bonds  are  not  cumu-j 
lative,  and  any  income  to  which  they  are  fairly  entitled  notj 
currently  received  is  utterly  lost,  unless  the  court  shall  decide 
to  order  a  new  accounting  from  the  date  of  reorganization, 
suit  calling  for  such  action  is  now  pending." 

That  holders  of  income  bonds  may  sometimes  have  t( 
content  themselves  for  a  long  period  without  obtaining  eithei 
income  or  a  return  of  any  of  their  principal  is  clear  from  th( 
report  of  the  Comstock  Tunnel  Company.  This  company  has 
outstanding  $2,769,000  first  income  4*5,  on  which  no  interest 


*Lyon  on  "Capitalization,"  p.  49. 


BORROWED   CAPITAL— LONG-TERM 


157 


has  been  paid  since  1892.  An  extraordinarily  weak  claim  is 
that  of  the  Reading  deferred  income  bonds,  which  are  not 
entitled  to  interest  until  after  the  common  stock  has  received 
6%  dividends. 

Although  new  issues  of  income  bonds  have  been  rare  in 
recent  years,  the  Hudson  and  Manhattan  Company  put  out 
in  1 91 3  a  series  of  contingent  income  bonds.  In  industrial 
corporations  they  are  rarely  to  be  found.  Out  of  40  or  more 
industrial  security  issues  discussed  in  Dewing's  "Corporate 
Promotions  and  Reorganizations,"  only  two  are  income  bonds, 
those  of  the  Mount  Vernon- Woodberry  Company  and  the 
Standard  Rope  and  Twine  Company.  The  Mount  Vernon-- 
Woodberry  bonds  were  secured  by  a  second  mortgage  on  all 
the  fixed  assets  and  a  direct  lien  on  all  the  merchandise  and 
quick  assets.  They  proved  a  constant  source  of  controversy 
and  greatly  handicapped  the  company  in  securing  short-term 
bank  credit  which  is  especially  essential  in  textile  manufac- 
turing. The  indenture  of  these  income  bonds  was  faulty  in 
that  it  made  no  provision  for  allowing  depreciation  before 
figuring  net  earnings,  thus  giving  rise  to  many  impossible 
demands  on  the  part  of  the  dissatisfied  income  bond- 
holders.* 

Income  bonds  and  stock  are  used  to  a  limited  extent  also 
in  English  practice.  The  same  objections,  however,  have 
arisen  there  as  in  this  country,  and  the  tendency  is  in  favor  of 
other  securities  which  give  less  room  for  misunderstanding 
and  controversy.  The  Lancashire  Power  Construction  Com- 
pany, Ltd.,  has  outstanding  an  issue  of  income  stock  which  was 
issued  as  a  bonus  to  subscribers  to  debenture  stock.  The  in- 
come stock  is  entitled  to  75%  of  the  net  profits  after  deducting 
interest  on  bonds  and  debentures,  and  the  principal  is  repay- 
able, in  case  the  company  is  wound  up,  after  prior  debts  have 
been  liquidated. 


^Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.  340,  363,  606. 


158 


CAPITAL 


Convertible  and  Participating  Bonds 

Most  purchasers  of  the  bonds  of  high  grade  companies  are 
primarily  interested  in  the  safety  of  their  principal  plus  a 
moderate  rate  of  return.  Most  purchasers  of  shares,  on  the 
other  hand,  are  primarily  interested  in  securing  profits  due 
to  the  enhancement  of  the  value  of  their  holdings,  plus  as 
high  a  rate  of  return  as  they  can  secure.  If  they  purchase 
stock  with  their  eyes  open,  they  realize  that  they  are  volun- 
tarily incurring  more  or  less  risk.  Between  these  two  main 
bodies  of  purchasers  of  corporate  securities,  there  are  a  great 
many  investors  who  wish  to  secure  reasonable  safety  com- 
bined with  a  reasonable  chance  for  appreciation  in  the  value 
of  their  holdings.  Preferred  shares  are  intended  in  part  to 
meet  the  wishes  of  this  intermediate  class.  Convertible  and 
participating  bonds  are  designed  also  to  appeal  to  this  group. 

The  adjective  "convertible"  in  itself  has  no  definite  mean- 
ing. The  bonds  may  be  convertible  into  anything  on  any 
terms.  Ordinarily,  however,  the  convertible  feature  gives  to 
bondholders  the  privilege  of  exchanging  their  bonds  within 
certain  time  limits  and  at  a  rate  fixed  in  advance,  for  the 
corporation's  common  shares.  The  bondholder  may  reason 
that  he  secures  under  this  arrangement  a  sound  and  safe  se- 
curity which  yields  a  moderate  rate  of  return  and  in  addition 
has  a  chance  of  speculative  profits  due  to  the  possible  enhance- 
ment in  the  value  of  the  company's  shares.  Thus,  the  Union 
Pacific  Railroad  Company's  issue  in  1901,  of  $100,000,000 
of  4%  bonds,  which  were  convertible  into  common  stock  at 
par  before  the  expiration  of  this  conversion  privilege,  sold 
considerably  higher  than  par.  Practically  all  of  this  issue  was 
converted  and  its  holders  obtained  a  sizable  profit.  It  has  not 
been  unknown  for  original  purchasers  of  these  securities  to 
obtain  profits  in  this  manner  running  as  high  as  25  to  50%  ; 
this  is  in  addition  to  the  normal  rate  of  interest  on  their 
investment. 


BORROWED   CAPITAI^LONG-TERM  159 

There  is,  of  course,  the  corresponding  drawback  that  the 
conversion  privilege,  if  it  is  really  valuable,  increases  the  sell- 
ing price  of  the  bonds  and  this  lowers  slightly  the  yield  on  the 
investor's  capital.  However,  in  view  of  the  fact  that  the 
large  buyers  of  bond  issues  are  institutions  which  are  not  at- 
tracted by  the  possibility  of  speculative  profits,  it  has  been 
found  that  those  who  were  willing  to  purchase  the  convertible 
bonds  of  good  companies  are  frequently  able  to  get  them  at 
a  very  reasonable  price.  There  are,  of  course,  all  shades  of 
variations  in  the  attractiveness  of  convertible  bonds.  The 
Pennsylvania  Railroad  Company  has  put  out  some  issues  which 
are  convertible  into  common  stock  at  such  a  high  rate  of  ex- 
change that  there  seems  to  be  no  probability  that  the  conversion 
privilege  will  become  valuable. 

From  the  corporation's  point  of  view  there  are  obvious 
objections.  It  may  well  be  argued  that  the  company  is  taking 
the  chances.  If  its  business  moves  along  successfully  and  its 
stock  increases  in  value,  the  holders  of  convertible  bonds  share 
in  the  prosperity  without  having  shared  in  the  preliminary 
risks.  On  the  other  hand,  in  case  some  unforeseen  misfortune 
reduces  the  company's  earnings,  the  convertible  bondholder 
naturally  enforces  his  claim  with  the  same  rigor  as  any  other 
creditor.  As  a  matter  of  fact,  convertible  bonds  are  seldom 
issued  except  in  periods  when  the  demand  for  capital  is  large 
and  when  it  is  necessary  for  corporations — even  those  in 
highest  standing — to  make  concessions.  In  the  United  States, 
these  securities  were  first  issued  during  and  after  the  Civil 
War.  The  financing  of  the  Chicago,  Milwaukee  and  St.  Paul 
Railroad  Company  from  i860  to  1880  was  chiefly  effected 
through  issues  of  convertible  bonds,  and  it  is  stated  that  as 
late  as  1896  there  were  twelve  separate  convertible  issues  of 
this  company  outstanding.  From  1880  to  1900,  on  the  other 
hand,  the  practice  was  discontinued  and  was  generally  thought 
to  have  become  obsolete.    Since  1900  there  has  been  a  revival 


l6o  CAPITAL 

of  convertible  issues,  which  is  to  be  explained  chiefly  on  the 
ground  of  increased  demand  for  capital. 

Among  the  convertible  bonds  now  outstanding  may  be 
mentioned : 

Atchison  4's,  due  1955,  which  were  convertible  up  to 
June  I,  19 1 3,  into  common  stock  at  100. 

Union  Pacific  Debenture  4's,  due  1927,  convertible  prior 
to  July  I,  191 7,  into  common  stock  at  175. 

American  Telegraph  and  Telephone  Company's  deben- 
ture 4's,  convertible  up  to  March  i,  191 8,  into  stock 
at  1337374. 

Participating  bonds  attempt  to  offer  a  like  advantage  by 
giving  to  the  bondholders  a  right  to  share  in  excess  profits 
after  all  the  obligations  of  the  company  have  been  provided 
for.  They  are  like  income  bonds  except  that  it  is  obligatory 
on  the  part  of  the  company  to  pay  the  fixed  rate  of  interest, 
and  the  participating  feature  applies  only  to  excess  payments. 
The  best  known  issue  of  this  kind  was  the  "Oregon  Short  Line 
Cumulative  Trust  Participating  4's"  issued  in  1903  but  almost 
immediately  retired,  which  were  to  receive  4%  interest  plus 
whatever  dividends  in  excess  of  this  amount  were  declared 
upon  the  stock  of  the  Northern  Securities  Company,  deposited] 
as  collateral. 

An  English  issue  of  the  same  type  consists  of  the  profit-] 
sharing  debentures  of  the  Anglo-Netherlands  Sugar  Corpora- 
tion, which  bear  interest  at  5%  and  in  addition  are  entitled  to] 
25%  of  the  surplus  net  profits  remaining  after  the  sinking  fund] 
has  been  provided  for  and  after  5  %  has  been  paid  on  ordinary] 
shares,  "such  participation,  however,  being  limited  to  an  ad- 
ditional 2}^%."  In  other  words,  these  debentures  cannot! 
under  any  conditions  pay  more  than  7J^%.  Participating  and] 
profit-sharing  bonds  have  not  proved  especially  popular  either] 
in  the  United  States  or  in  England. 


BORROWED   CAPITAL-LONG-TERM  l6i 

Sinking  Funds 

The  sinking  fund  principle  first  came  into  prominence  in 
the  latter  part  of  the  eighteenth  century,  when  it  was  ad- 
vocated and  applied  by  William  Pitt  as  the  best  and  easiest 
means  of  providing  for  the  repayment  of  the  United  King- 
dom's huge  national  debt.  It  was  heralded  by  many  people 
at  the  beginning  as  a  remarkable  method  of  repaying  the  loan 
without  any  perceptible  sacrifice.  As  a  matter  of  fact,  this  is 
in  many  instances  the  truth  of  the  case.  Corporations  are 
run  by  human  beings  who  are  more  than  likely,  if  left  to 
their  own  devices,  to  make  inadequate  provision  for  the  future. 
An  officer  of  a  corporation  which  has  just  floated,  let  us  say, 
a  25-year  loan,  is  likely  to  consider  that  his  duty  has  been 
done;  his  corporation  has  received  a  large  amount  of  fresh 
capital  which  can  be  profitably  used,  and  the  earnings  of 
which  (after  deducting  the  interest  payments)  will  go  to 
increase  the  yield  on  outstanding  stock.  It  is  easy  for  him 
to  think  that  it  is  not  his  part  to  worry  as  to  the  repayment 
of  the  loan.  When  it  begins  to  approach  maturity,  he,  or  his 
successor,  will  consider  how  it  should  be  handled. 

Against  this  every-day  human  attitude  of  directors  and 
managers  of  borrowing  corporations,  there  are  opposed  the 
interests  of  the  buyer  of  the  bond  and  of  his  representative 
in  the  preliminary  negotiations,  namely  the  banking  firm  which 
undertakes  to  dispose  of  the  bond  issue.  The  investor  wants 
to  make  sure  that  his  money  will  be  repaid  when  due.  Further 
[than  that,  he  wants  to  make  sure  that  there  will  be  no  depre- 
ciation in  the  market  value  of  his  holdings.  He  is  well  aware, 
as  every  lender  must  be,  that  the  borrower's  natural  instinct 
is  to  let  the  future  take  care  of  itself.  If  he  is  wise,  he  is 
strongly  inclined  to  insist  that  some  definite  measures  be 
idopted  which  will  fully  protect  him  against  the  carelessness 
)r  easy-going  optimism  of  the  people  to  whom  his  money  has 
)een  entrusted. 


l62  CAPITAL 

This  wise  demand  on  the  part  of  the  investor  can  readily 
be  met  without  great  difficulty.  The  fundamental  reason  for 
the  sinking  fund  or  some  other  method  of  beginning  at  once 
to  repay  a  loan,  is  to  be  found  in  the  fact  that  comparatively 
small  amounts  set  aside  each  year  out  of  the  corporation's 
earnings  will  assure  repayment,  unless  the  corporation  has 
overborrowed.  The  annual  provision,  accumulating  as  it  does 
at  compound  interest,  will  not  be  a  serious  burden.  Accumu- 
lating at  the  rate  of  6%,  a  sinking  fund  of  approximately 
4.3%  per  year  will  provide  for  repayment  of  a  loan  at  the  end 
of  1 5  years;  accumulating  at  a  rate  of  as  little  as  3%,  a  sink- 
ing fund  of  2.8%  per  annum  will  provide  for  repayment  of 
a  loan  at  the  end  of  25  years. 

A  corporation  should  be  able  to  withhold  these  amounts 
and  j'-et  have  ample  funds  remaining,  if  it  is  reasonably  pros- 
perous, for  dividends  to  its  stockholders.  It  is  clear  from 
the  approximate  figures  cited,  that  the  repayment  of  a  loan 
by  annual  deductions  from  income  is  especially  appropriate 
in  the  case  of  loans  running  from  20  to  50  years.  The  length 
of  the  loan  will,  of  course,  depend  upon  the  character  and 
stability  of  the  business.  A  loan  to  a  railroad  company  may 
properly  run,  it  is  generally  considered,  for  as  long  as  50 
years.  A  loan  to  an  industrial  corporation  will  ordinarily  not 
run  longer  than  25  years.  Inasmuch  as  the  profits  of  in- 
dustrial corporations  are  expected  to  average  higher  than  the 
profits  of  transportation  companies,  it  is  clear  that  they  should 
be  able  to  carry  a  larger  sinking  fund. 

Although  many  corporations  combat  the  tendency,  there 
can  be  little  question  but  that  the  demand  for  some  form  of 
sinking  fund  or  other  annual  repayment  is  growing.  The 
Committee  of  the  American  Investment  Bankers'  Association 
on  Railroad  Bonds  and  Equipment  Trusts,  included  among  its 
recommendations  at  the  191 5  meeting  of  the  association,  that 
"railroad   mortgages   should   contain   provisions    for   sinking 


BORROWED   CAPITAL— LONG-TERM  163 

funds,  and  that  such  sinking  fund  payments  should  be  recog- 
nized by  the  rate-making  bodies  as  an  operating  expense  of 
the  railroad  corporation." 

In  popular  usage  the  term  ''sinking  fund"  is  applied  almost 
indiscriminately  to  any  method  of  providing  for  repayment 
of  a  long-term  loan  during  its  life,  by  setting  aside  a  prede- 
termined amount  at  regular  periods  for  that  purpose.  This 
process  is  known  in  more  technical  language  as  ''amortiza- 
tion." In  its  proper  sense,  amortization  includes  four  principal 
methods  as  follows : 

1.  The  borrower  may  turn  over  fixed  cash  payments  at 

regular  periods,  usually  once  a  year  or  once  every 
six  months,  to  a  trustee ;  the  trustee  may  deposit  or 
invest  the  money  at  his  discretion  within  the  limits 
determined  in  the  original  agreement. 

2.  The  borrower  may  set  aside  fixed  sums  at  regular 

intervals  and  deposit  or  invest  these  sums  at  his  own 
discretion  within  the  limits  of  the  agreement. 

3.  The  borrower  may  set  aside  sums  at  regular  inter- 

vals and  use  them  solely  for  the  repurchase  of  the 
bonds  which  are  being  amortized. 

4.  The  bonds  may  be  arranged  to  mature  in  series  so 

that  a  predetermined  proportion  will  fall  due  each 
year,  thus  forcing  the  borrower  to  repay  the  bonds 
gradually  during  the  life  of  the  whole  issue. 

The  first  two  methods  are  the  ones  originally  in  view  under 
the  sinking  fund  plan.  They  are  still  used  to  a  considerable 
extent  in  the  repayment  of  municipal  and  some  other  govern- 
mental loans,  but  are  seldom  to  be  found  in  private  corpora- 
tions. The  third  and  fourth  methods  are  in  one  important 
respect  similar,  since  the  sums  set  aside  out  of  income  are 
used  under  both  methods  for  the  redemption  of  the  borrower's 
own  obligations,  not  for  the  purchase  of  outside  securities.    In 


164  CAPITAL 

applying  the  third  method,  the  bonds  which  are  repurchased 
by  the  corporation  are  frequently  kept  alive.  Interest  payments 
on  them  are  maintained,  in  which  case  it  may  properly  be 
designated  as  one  variety  of  sinking  fund.  In  other  instances 
the  bonds  that  have  been  redeemed  are  cancelled,  in  which 
case  the  third  method  closely  resembles  the  fourth  method. 

There  are  certain  objections  to  all  these  methods  which 
may  briefly  be  stated.  When  the  first-named  plan  of  turning 
over  regular  payments  to  a  trustee  is  followed,  there  is  always 
to  be  considered  the  possibility  that  the  trustee  may  invest  the 
funds  with  a  view  primarily  to  his  own  advantage,  or  may  make 
unsound  investments,  in  which  case  it  is  quite  possible  that  the 
fund  may  not  accumulate  as  rapidly  as  had  been  expected  in 
advance.  The  possibility  of  making  unwise  investments  is 
almost  equally  to  be  feared  under  the  second  method.  Fur- 
thermore, the  average  rate  of  return  on  high-class  investments 
varies  considerably  over  a  long  period  of  years,  and  this  may 
make  impracticable  even  an  approach  to  the  rate  of  accumula- 
tion which  had  been  calculated  in  advance.  It  is,  in  fact,  a 
matter  of  common  knowledge  that  sinking  funds  invested  in 
outside  securities  seldom  come  up  to  the  expectations  of  those 
who  plan  them.  The  final,  and  perhaps  most  serious,  objection 
to  both  the  first  and  second  methods  is  that  high-grade  invest- 
ments, which  are  the  only  ones  suitable  for  sinking  funds,  yield 
a  comparatively  small  rate  of  return;  as  a  matter  of  fact,  the 
rate  of  interest  received  on  such  securities  usually  is  consid- 
erably less  than  the  interest  which  is  being  paid  by  the  cor- 
poration on  its  own  obligations. 

These  objections  have  proved  so  powerful  and  well 
founded,  that  it  has  come  to  be  almost  universally  accepted  as 
correct  practice  to  carry  on  amortization  through  the  redemp- 
tion of  bonds  which  are  being  amortized.  The  practical  ques- 
tion for  most  corporations  to  consider  is  whether  it  is  best  to 
set  aside  fixed  amounts  for  the  redemption  of  their  securities, 


BORROWED   CAPITAI^LONG-TERM  165 

or  to  arrange  for  serial  maturity  of  these  securities.  For  short- 
term  loans  the  tendency  is  strongly  toward  the  convenience  and 
simplicity  of  the  last-named  method.  For  long-term  loans, 
however,  the  third  method  is  probably  better  adapted.  There 
are  two  fundamental  reasons  for  this  preference :  first,  when 
an  issue  of  long-term  bonds  has  different  dates  of  maturity,  it 
is  necessary  to  fix  a  distinct  price  for  each  maturity,  which  is 
inconvenient  and  in  large  part  offsets  the  advantage  of  ready 
marketability  which  should  attach  to  all  large  bond  issues; 
second,  unless  the  amount  falling  due  at  each  date  of  maturity 
is  arranged  on  a  graduated  scale  so  that  the  amounts  become 
progressively  larfer,  the  burden  on  the  corporation  is  heavier 
at  the  beginning  when  interest  payments  on  the  whole  issue 
must  be  met,  and  is  gradually  lightened  as  more  and  more  of 
the  bonds  are  redeemed  and  interest  payments  are  thereby 
reduced.  It  is  far  better,  if  possible,  to  retain  the  advantage  of 
uniformity  in  the  life  of  all  the  bonds  in  one  issue,  and  of  an 
equal  distribution  of  the  burden  over  a  period  of  years,  both  of 
which  are  attractive  features  of  the  original  sinking  fund  plan. 
The  simplest  and  no  doubt  the  favorite  device  for  meeting 
all  these  objections,  is  to  establish  a  sinking  fund  and  invest 
the  fund  solely  in  bonds  that  are  being  amortized.  Among  the 
beneficial  results  of  this  method  are  the  following : 

1.  The  corporation  is  protected  against  any  loss  due  to 
unwise  investment,  when  it  is  buying  its  own  bonds,  and 
thereby  reducing  its  outstanding  obligations.  It  is  certainly 
in  no  danger  of  losing  Its  money. 

2.  The  rate  of  interest  earned  is  the  same  as  the  yield  of 
the  market  price  of  the  bonds  that  are  being  amortized.  This 
is  an  accurate  statement,  at  least  under  the  customary  provi- 
sions that  the  bonds  may  be  redeemed  for  the  sinking  fund 
at  par  or  slightly  above,  or  may  be  purchased  in  the  open 
market  at  the  option  of  the  corporation,  in  case  the  market 
price  is  below  the  fixed  redemption  price.     If  the  bonds  are 


l66  CAPITAL 

selling  on  a  6  or  7%  basis,  it  is  clear  that  the  sinking  fund 
will  accumulate  at  the  same  rate. 

3.  Under  the  customary  provisions  just  referred  to,  the 
market  price  of  the  bonds  is  maintained  by  the  corporation's 
repurchases  or  redemption,  and  in  this  way  the  credit  of  the 
corporation  is  supported. 

4.  There  is  nothing  to  prevent  making  a  single  quotation 
for  all  bonds  in  the  issue.  If  a  corporation  buys  in  the  open 
market,  it  takes  whatever  bonds  happen  to  be  for  sale  at  the 
market  price.  If  it  redeems  a  fixed  proportion  of  bonds  each 
year,  the  bonds  to  be  redeemed  are  customarily  determined  by 
lot.  In  this  last  practice  there  is  a  slight  element  of  uncer- 
tainty which  might  be  considered  objectionable,  but  it  is  of 
small  practical  importance. 

5.  The  burden  on  the  corporation  is  equally  distributed 
during  the  life  of  the  bond  issue.  The  simplest  plan  for 
accomplishing  this  result  is  to  keep  alive  all  the  bonds  pur- 
chased for  the  sinking  fund,  so  that  the  corporation  pays  out 
the  same  amount  of  interest  each  year.  As  the  number  of 
bonds  held  in  the  sinking  fund  increases  more  and  more,  in- 
terest payments,  it  is  clear,  go  to  swell  the  sinking  fund,  and 
thus  to, increase  the  annual  purchases  or  redemptions.  But 
so  far  as  the  burden  on  the  corporation  is  concerned,  it  re- 
mains the  same  year  after  year. 

There  seems  to  be  little  room  for  question  that  among  all 
the  methods  of  amortization,  the  best  and  simplest  is  the  one 
just  described  of  establishing  a  sinking  fund  which  is  used 
for  the  repurchase  and  redemption  of  all  the  bonds  that  are 
being  amortized,  and  keeping  alive  the  bonds  that  are  taken 
into  the  sinking  fund. 

A  Novel  Proposal 

It  may  be  of  interest  to  readers  in  connection  with  the 
preceding  review  of  sinking  fund  methods,  and  as  showing 


I 


BORROWED   CAPITAL— LONG-TERM  167 

how  the  principles  that  have  been  stated  are  applied  in  prac- 
tice, to  review  briefly  a  somewhat  novel  proposal  for  the 
redemption  of  a  bond  issue  which  was  presented  to  the  writer 
some  years  ago.  The  proposal  may  be  regarded  as  typical  of 
a  number  of  ingenious  plans  which  on  analysis  are  generally 
found  to  be  unsound. 

The   essential  points   of  the   proposal  may  be   stated   as 
follows : 

A  manufacturing  concern,  a  corporation,  wishes  to 
increase  its  working  capital  by  $400,000.  It  has  at  pres- 
ent about  $300,000  worth  of  paper  in  the  banks  and 
desires  to  make  this  a  permanent  loan  in  order  to  be 
able  to  take  care  of  future  increase  of  business  by  addi- 
tional bank  credit  if  it  should  be  necessary.  The  plan 
under  consideration  is  the  issue  of  $400,000  of  50-year 
6%  debenture  bonds  without  any  mortgage,  secured  by  a 
general  charge  against  the  property. 

A  redemption  fund  is  to  be  provided  by  the  corpora- 
tion's procuring  a  trust  company  to  act  as  trustee  for  a 
fund  of  $72,000.  This  is  to  be  invested  at  the  trust  com- 
pany's discretion,  so  that  it  will  yield  4%  per  annum,  and 
the  above  amount  at  this  rate,  compounded  semiannually, 
in  fifty  years  will  amount  to  $520,000,  or  $120,000  more 
than  sufficient  to  pay  the  bonds  at  maturity. 

The  borrowing  corporation  would  therefore  receive 
from  this  issue  $328,000  and  at  the  expiration  of  the 
50-year  term  $120,000  additional. 

The  trust  company's  remuneration  is  to  come  from 
whatever  it  can  make  above  4%  on  this  $72,000. 

Will  you  give  me  your  opinion  as  to  whether  you 
would  consider  this  good  business  on  the  part  of  the 
corporation  and  what  you  would  think  of  the  bonds 
aside  from  the  question  of  the  credit  of  the  borrowing 
company. 

In  putting  this  matter  before  a  trust  company  to  act 
as  trustee,  for  the  redemption  fund,  what  objections,  if 
any,  would  hkely  be  made?  Do  you  know  of  any  bond 
issues  of  this  kind? 


1 68  CAPITAL 

The  reply  to  this  inquiry  was  as  follows: 

Your  plan  for  providing  for  the  ultimate  redemption 
of  a  bond  issue,  is  unusual.  We  do  not  know  of  any 
bonds  issued  under  similar  conditions.  For  the  reasons 
presented  below,  the  plan  seems  to  us  wasteful  and  objec- 
tionable. 

First,  and  most  important  of  all,  it  would  seem  to  us 
very  unwise  to  turn  over  $72,000  to  any  individual  or 
institution  to  be  invested  at  the  discretion  of  the  trustee, 
with  the  provision  that  the  trustee  is  to  retain  as  profits 
whatever  income  is  secured  above  4%.  Under  this 
arrangement  the  trustee  is  given  every  inducement  to 
secure  just  as  large  an  income  as  possible,  even  if  the 
principal  be  risked.  In  other  words,  the  trustee  is  left 
free  to  speculate  with  other  people's  money. 

It  may  be  claimed,  on  the  other  side,  that  a  highly 
reputable  conservative  trust  company  would  be  chosen  as 
trustee  and  that  this  trust  company  would  be  responsible 
for  the  original  sum  with  interest  compounded  at  4%.  But 
you  must  remember  that  50  years  is  a  long  time  and  that 
no  man  can  foresee  what  changes  in  ownership  and 
management  may  take  place  before  the  end  of  the  period. 

Moreover,  4%  is  about  all  that  can  be  secured  on 
thoroughly  safe  investment  bonds  at  the  present  time. 
The  proposed  plan,  therefore,  would  make  it  imperative 
on  the  trustee  to  invest  in  more  or  less  doubtful  securi- 
ties. Under  these  conditions,  we  doubt  very  much  if 
any  first-class  trust  company  would  consent  to  act  as 
trustee. 

The  rate  of  return  on  sinking  funds  invested  in  out- 
side securities  is  always  uncertain,  and,  as  experience 
has  shown,  almost  always  disappointing.  The  best 
modern  practice  in  handling  sinking  funds,  therefore,  is 
to  invest  them  in  the  very  bonds  which  the  sinking  fund 
is  designed  to  protect.  These  bonds  may  be  secured 
either  by  purchase  in  the  open  market  or  by  providing  at 
the  beginning  that  they  may  be  called  and  redeemed  at 
a  good  price,  usually  considerably  above  par.  As  bonds 
backed  by  sinking  funds  usually  bear  comparatively  high 


BORROWED   CAPITAI^LONG-TERM  169 

rates  of  interest,  this  method  of  investment  is  not  only 
safe,  from  the  corporation's  standpoint,  and  the  returns 
certain,  but  also  results  in  a  much  larger  saving  than  is 
possible  by  conservative  investment  in  outside  securities. 
In  the  present  case,  for  instance,  a  sinking  fund  so 
invested  would  yield  a  return  of  6%  instead  of  4%. 

Another  criticism  of  this  bond  issue  is  that  the  life 
of  the  bond  is  too  long.  Scarcely  any  industrial  cor- 
poration is  so  firmly  established  that  its  bonds  can  safely 
be  bought  when  they  run  over  a  50-year  period — not,  at 
least,  unless  some  of  the  bonds,  as  with  the  United  States 
Steel  issue,  are  bought  up  and  put  into  the  sinking  fund 
each  year.  For  this  reason  alone  we  do  not  believe  that 
the  bonds  under  the  proposed  plan  would  find  a  ready 
market. 

Another  objection  is  that  the  proposed  plan  is  ex- 
pensive. The  corporation,  assuming  that  the  bonds  are 
sold  at  par,  will  secure  $400,000,  $72,000  of  which  will 
go  into  the  redemption  fund,  leaving  only  $328,000  for 
the  company.  The  $72,000  will  draw  only  4% ;  yet  the 
company  must  pay  6%  on  the  whole  $400,000. 

The  net  expense  to  the  corporation  consists  of  the 
yearly  interest  payment  less  the  annuity  which,  if  set 
aside  each  year  and  invested  at  4%,  would  equal  $120,000 
at  the  end  of  50  years.  This  annuity  is  $786.02.  The 
net  expense  to  the  corporation,  therefore,  is  $24,000  less 
$786.02,  which  equals  $23,213.98,  equivalent  to  7.08%  on 
the  $328,000  actually  received. 

If,  instead  of  the  redemption  fund,  the  ordinary 
sinking  fund  invested  in  outside  securities  at  4%  were 
used,  the  yearly  exoense  would  be  as  follows: 

6%  on  $328,000 $19,680.00 

Plus  sinking  fund  yearly  payment  which 
accumulating  at  4%  would  equal  $328,000  at 
the  end  of  50  years 2,148.47 

Total $21,828.47 

This  latter  sum  is  6.65%  on  $328,000. 


I^O  CAPITAL 

If  the  sinking  fund,  as  suggested  above,  were  invested 
in  the  corporation's  own  bonds,  there  would  be  a  still 
greater  saving.  The  exact  amount  of  this  saving  would 
depend  on  the  price  at  which  the  bonds  were  redeemed 
or  bought  in  the  open  market,  and  cannot,  therefore,  be 
calculated  precisely  in  advance — not  at  least  unless  the 
rate  of  redemption  is  fixed  at  the  time  the  bonds  are 
issued. 

Other  Methods  of  Safeguarding  Bonds 

The  bond  issues  put  out  by  mining  companies,  lumber 
companies,  and  other  concerns,  the  chief  property  of  which 
consists  of  ''wasting  assets" — that  is,  assets  which  in  the  ordi- 
nary course  of  business  are  used  up  and  not  replaced — are 
customarily  protected  by  sinking  funds  calculated  on  the  an- 
nual wastage.  Timber  bonds,  for  instance,  which  are  secured 
by  tracts  of  standing  timber,  are  customarily  issued  up  to 
about  50%  of  the  market  value  of  the  timber.  The  mortgage 
securing  the  bonds  must  contain  strict  provisions  which 
operate  to  insure  the  regular  deposit  of  an  agreed  amount  per 
thousand  feet  for  all  timber  cut  sufficient  to  retire  all  the 
bonds  when  about  one-half  of  the  timber  is  consumed;  these 
deposits  to  be  applied  to  the  payment  of  principal  of  the  bonds 
as  the  several  serials,  semiannually  or  annually,  become  due. 
The  mortgage  makes  provision  for  keeping  careful  check  upon 
the  cutting  of  the  timber  and  accounting  for  the  same  to  the 
mortgage  trustee.* 

$3  to  $3.50  per  thousand  feet  of  lumber  seems  to  be 
generally  regarded  as  a  fair  sinking  fund  provision.  The  same 
principle  is  followed  in  accumulating  sinking  funds  for  mines. 
For  example,  the  Great  Lakes  Coal  Company  sets  aside  for 
this  purpose,  5  cents  per  ton,  run  of  mine  coal.  The  Iroquois 
Iron  Company  sets  aside  25  cents  for  each  of  the  first  400,000 
tons  of  iron  ore  mined  and  shipped  each  year,  with  an  addi- 


*Extract   from   circular   issued   by    Messrs.    Clark   L.   Poole  and    Company,   quoted 
in  T.  S.  McGrath's  "Timber  Bonds,"  p.  34. 


BORROWED   CAPITAL— LONG-TERM 


i;t 


tional  15  cents  per  ton  on  all  shipments  running  in  excess  of 
400,000  tons. 

There  are  many  different  special  provisions  for  the  main- 
tenance of  sinking  funds  and  for  giving  greater  security  to 
bondholders.  In  1899  the  New  England  Cotton  Yarn  Com- 
pany issued  $6,500,000  5%  first  mortgage  bonds  which  were 
covered  by  a  sinking  fund  of  1%  on  the  outstanding  amount, 
payable  before  any  dividend  disbursements  on  the  preferred 
stock,  with  an  additional  sinking  fund  of  4%  payable  before 
any  dividend  disbursements  on  the  common  stock.  The  Bald- 
win Locomotive  Works  has  an  authorized  issue  of  $10,000,- 
000  first  sinking  fund  gold  5's,  the  mortgage  of  which  provides 
that  the  net  quick  assets  of  the  corporation  shall  at  all  times 
equal  the  aggregate  indebtedness  including  the  outstanding 
bonds.  Similar  provisions  requiring  that  net  quick  assets 
shall  bear  a  fixed  relation  to  the  total  indebtedness  are  not 
uncommon  with  manufacturing  and  trading  companies. 


CHAPTER    VIII 

BASIS    OF    CAPITALIZATION 

Definitions 

We  have  now  considered  the  financial  forms  of  organiza- 
tion of  business  enterprises  and  the  various  types  of  security 
issues  which  are  exchanged  for  cash  and  other  property  ac- 
quired by  the  business.  The  total  par  value  of  all  the  security 
issues  outstanding  at  any  given  time  is  usually  referred  to 
as  the  "capitalization"  of  an  enterprise.  In  some  jurisdictions 
there  is  a  legal  meaning  attached  to  the  word  ''capitalization" 
which  is  wholly  distinct  from  its  popular  meaning;  it  being, 
in  the  legal  sense,  the  total  par  value  of  the  authorized  capital 
stock  of  a  corporation.  Wherever  the  word  is  used  in  this 
volume,  however,  it  may  be  understood  in  its  popular  sense. 

"Capitalization"  is  distinguished  from  "capital"  or  "capital 
funds,"  by  which  we  mean  the  actual  value  of  the  investment 
in  the  business.  The  vague  expression  "overcapitalization" 
is  intended  to  indicate  a  state  of  affairs  where  the  nominal 
value  of  the  outstanding  stocks  and  bonds  is  in  excess  of  the 
real  value  of  the  investment.  It  has  already  been  pointed  out 
in  discussing  methods  of  paying  for  capital  stock,  that  there 
need  not  necessarily  be  a  close  correspondence  between  "capi- 
talization" and  "capital"  or  "capital  funds"  actually  invested. 

Another  phrase  frequently  used  which  should  be  dis- 
tinguished, is  "capital  assets,"  under  which  term  are  included 
those  assets  of  a  business  which  are  of  a  permanent  nature 
and  which  are  essential  to  its  continuance.  "Capital  assets" 
are  distinguished  from  "current  assets."  If  a  manufacturing 
concern,  for  instance,  has  a  plant  worth  $1,000,000,  inven- 
tories of  $300,000,  and  cash  and  accounts  receivable  of  $200,- 

172 


BASIS    OF   CAPITALIZATION 


173 


000,  we  should  say  that  its  capital  assets  were  $1,000,000  and 
its  current  assets  $500,000. 

The  capitalization  of  an  enterprise  is  in  a  sense  a  valua- 
tion on  the  part  of  the  organizers  of  the  net  worth  of  the 
enterprise.  At  the  beginning  it  is  supposed  to  be,  at  least  as 
a  matter  of  legal  theory,  a  fairly  accurate  valuation.  As 
time  goes  on,  it  is  recognized  that  there  will  necessarily  be 
changes  in  the  status  and  value  of  the  various  assets  and 
liabilities;  and  the  financial  results  of  these  changes  are  sup- 
posed to  be  shown  in  the  surplus  or  profit  and  loss  accounts. 
The  "capitalization"  plus  the  surplus  theoretically  measures 
the  exact  value  of  the  permanent  investment  in  the  business. 
However,  the  necessary  inaccuracies  and  arbitrary  estimates 
of  accounting  practice  make  it  very  difficult  even  to  approach 
this  theoretical  relation  in  every-day  practice. 

Three  Bases  of  Capitalization 

The  question:  "What  is  the  right  basis  of  capitalization?", 
is  almost  identical  with  the  question:  "What  is  the  best 
measure  of  wealth?"  To  this  latter  question  there  are  three 
possible  answers.  The  most  obvious  is  that  wealth  is  measured 
by  the  cost  of  the  property  which  is  owned,  plus  whatever 
surplus  value  has  been  accumulated.  Thus,  if  a  farm  cost 
$10,000  and  has  been  improved  to  the  extent  of  $500  a  year, 
it  should,  in  the  course  of  two  years,  be  worth  $11,000.  But, 
supposing  that  before  the  end  of  the  two  years  some  one 
in  the  neighborhood  struck  oil?  The  property  would  imme- 
diately acquire  a  value  which  would  have  very  little  reference 
to  the  original  investment  in  the  accumulation  of  betterments. 
Unexpected  factors  wholly  outside  the  control  of  the  owner  of 
property  are  continually  modifying  its  value  so  that  it  is  quite 
out  of  the  question  for  anyone  to  depend  wholly  on  records 
of  his  investments  and  of  accumulations  as  a  method  of 
measuring  his  wealth. 


174 


CAPITAL 


The  second  method  Is  to  measure  wealth  by  the  cost  of 
reproducing  property.  If  a  man  has  a  factory  which  has  been 
running  for  20  years,  he  may  be  ready  to  grant  that  his 
records  of  investments  and  accumulations  would  be  of  little 
use  in  determining  its  value  but  he  might  suggest  that  the 
present  cost  of  building  another  plant  of  the  same  quality  and 
size  would  be  a  correct  measure  of  its  value.  This  may  be 
accepted  as  satisfactory  so  far  as  strictly  tangible  assets  are 
concerned.  But  to  every  piece  of  property  there  attaches  a 
certain  intangible  value.  A  man  running  a.  successful  retail 
shop  would  not  be  willing  to  part  with  it,  ordinarily,  in  ex- 
change for  another  shop  which  was  just  as  well  fitted  up  and 
carried  the  same  stock  but  which  had  been  unsuccessful.  A 
street  railway  company  that  was  running  smoothly  and  in 
harmony  with  the  public  sentiment  of  its  territory  would  not 
accept  in  exchange  for  its  track  and  rolling  stock  the  exactly 
similar  assets  of  some  other  company  which  had  incurred 
public  ill-will.  It  is  possible — at  least  theoretically — to  re- 
produce physical  assets,  but  it  is  impossible  to  reproduce  good- 
will, organization,  prestige,  and  the  like.  Hence,  the  attempt 
to  measure  wealth  by  figuring  the  cost  of  reproducing  proper- 
ties breaks  down  as  soon  as  we  begin  to  measure  the  value  of 
intangible  assets. 

The  third  method  is  the  capitalization  of  earning  power. 
One  man  owns  a  piece  of  real  estate,  which  brings  him  a  clear 
net  income  under  a  long-term  lease,  of  say  $50,000  a  year; 
another  man  owns  a  piece  of  property  for  which  he  paid  just 
as  much  but  which  yields  only  $10,000  a  year.  Assuming  that 
these  two  incomes  are  equally  stable,  can  there  be  a  question 
in  anyone's  mind  that  the  first  property  is  worth  five  times 
as  much  as  the  second?  Note  the  assumption  that  the  two 
incomes  are  equally  stable.  The  likelihood  of  continuance  of 
earning  power  and  the  ease  with  which  it  may  be  transferred 
are,  of  course,  important  factors  to  be  considered.    To  what 


BASIS   OF   CAPITALIZATION 


175 


extent  they  should  be  allowed  for,  and  in  what  way  the  value 
of  any  given  property  is  to  be  determined  on  the  basis  of  its 
earning  power,  are  questions  to  be  discussed  a  little  farther 
on  in  this  chapter.  It  is  enough  here  to  point  out  that  earning 
power  is  the  chief  result  of  tangible  and  of  intangible  assets. 
If  we  take  into  account  not  merely  current  earnings  but  also 
potential  earnings,  then  we  have  here  a  measure  of  wealth 
which  must  be  a  true  and  satisfactory  measure.  After  all, 
in  buying  property  for  business  reasons,  what  do  we  buy? 
Not  merely  so  much  real  estate  or  so  many  articles.  We  are 
buying  income.  In  the  same  way  a  man's  individual  wealth  is 
shown,  not  by  what  he  has  invested — which  may  have  been 
chiefly  wasted — but  by  what  he  is  getting  out  of  his  invest- 
ments. If  the  answer  that  earning  power  is  the  best  measure 
of  wealth  is  granted,  and  if  the  proposition  that  "capitaliza- 
tion" of  an  enterprise  is  an  approximate  estimate  of  its  wealth 
is  accepted,  then  it  would  seem  to  follow  that  the  correct  basis 
of  "capitalization"  is  earning  power.  This  answer,  however 
simple  and  sound  it  may  appear  to  us,  is  not  a  principle  of 
the  law  governing  corporations  which,  on  the  contrary,  as- 
sumes that  investment  is  the  only  correct  basis  of  capitaliza- 
tion. Out  of  this  conflict  between  legal  theory  and  business 
practice  grow  many  difficulties  and  evasions. 

Investment  as  a  Basis  of  Capitalization 

Small  and  close  corporations  are  usually  started  through 
informal  agreements  among  a  few  men  who  are  personally 
acquainted  with  each  other.  Each  one  of  these  men  subscribes 
to  a  certain  amount  of  stock  of  the  new  corporation  and  pays 
for  his  stock  either  in  cash  or  by  turning  over  property  at  a 
value  agreed  upon  with  his  associates  in  the  enterprise.  With 
comparatively  few  exceptions,  corporations  of  this  type  issue 
their  bonds  and  capital  stock  at  a  par  value  exactly  or  nearly 
equivalent  to  the  cash  or  cash  value  which  the  corporation 


1^6  CAPITAL 

receives.  Thus  at  the  beginning  there  is  an  actual  corre- 
spondence between  the  capitaHzation,  the  investment,  and  the 
actual  net  worth  of  the  corporation's  assets.  If  the  enterprise 
operates  along  well  established  lines,  has  the  correct  amount 
of  capital,  and  earns  a  normal  rate  of  return,  there  will  be 
little  divergence  from  this  system  of  approximate  equality 
among  the  three  factors  mentioned.  Ordinarily,  however,  the 
vicissitudes  of  business  soon  bring  about  variations.  With 
a  larger  corporation  there  is  usually  no  very  close  correspon- 
dence, even  at  the  beginning.  It  has  been  remarked:  "New 
companies  nearly  always  start  with  a  burden  on  their  backs. 
Either  they  have  to  spend  a  great  deal  in  order  to  get  their 
capital,  or  they  pay  a  great  deal  for  the  good- will  of  an 
established  business."* 

The  wide  discrepancy  that  may  exist  between  investment 
and  actual  value  is  most  forcibly  illustrated  by  the  history 
of  the  so-called  "Cordage  combination"  which  began  as  the 
National  Cordage  Company  in  1887,  became  after  the  first 
reorganization  in  1893  the  United  States  Cordage  Company, 
and  after  the  second  reorganization  in  1895  the  Standard 
Rope  and  Twine  Company.  Arthur  F.  Dewing  has  calculated 
the  results  to  the  original  investors  in  this  unfortunate  enter- 
prise as  follows: 

For  purposes  of  illustration  consider  a  private  in- 
vestor having  bought  ten  shares  of  the  National  Cordage 
Company's  preferred  stock  of  Belmont  &  Co.  fn  1890. 
In  the  reorganization  of  the  National  Company  he  was 
compelled  to  buy  twenty  per  cent  more  of  the  pre- 
ferred stock,  all  of  his  holdings  becoming  second  pre- 
ferred. He  would,  therefore,  come  into  possession  of 
twelve  shares  of  the  United  States  Cordage  Company's 
second  preferred  stock — cost  $1,200.  He  received  no 
dividends.  In  the  reorganization  of  the  United  States 
Cordage   Company,  the  second  preferred  stock  was  as- 


^Hartley  Withers  on  "Stocks  and  Shares,"  p.  74. 


BASIS    OF   CAPITALIZATION  177 

sessed  $10  a  share  and  received  $10  a  share  of  the  First 
Mortgage  Bonds  of  the  Standard  Rope  and  Twine  Com- 
pany and  forty  per  cent  of  stock.  The  investor  in 
question  would  be  assessed  $120 — making  his  actual  in- 
vestment $1,320.  He  received  $120  in  the  Standard  Rope 
and  Twine  Bonds  and  $480  in  stock.  In  the  reorganiza- 
tion of  the  latter  Company  the  stock  was  extinguished. 
The  bonds  were  worth  thirty-nine  per  cent  and,  if  re- 
tained, would  be  subject  to  an  assessment.  The  $120 
in  bonds  represented  an  actual  value  to  the  investor  of 
$46.80.  Meanwhile,  he  would  have  lost  the  interest  on 
the  investment  for  upwards  of  twelve  years.  Taking 
this  at  the  rate  of  five  per  cent  the  indirect  loss 
amounted  to  $780.  A  man  who  invested  $1,000  in  the 
first  and  underlying  security  of  the  National  Cordage 
Company  would,  in  1905,  have  increased  his  actual  in- 
vestment to  $1,320,  and  including  interest  to  $2,100.  For 
this  he  would  have  stock  that  was  worthless  and  bonds 
having  a  market  value  of  $46.80  and  subject  to  further 
assessment.* 

On  the  other  side  may  be  given  numerous  examples  of 
corporations  the  fortunate  stockholders  in  which  have  seen 
the  market  vakie  of  their  shares  rise  with  great  rapidity.  It 
needs  no  further  argument  to  satisfy  every  one  that  however 
closely  investment,  capitalization,  and  net  worth  may  corre- 
spond at  the  beginning  of  an  enterprise,  they  are  likely  to 
diverge  more  and  more  as  time  goes  on. 

Capitalization  of  Initial  Expenses  and  Losses 

A  question  which  arises  in  the  early  history  of  most  cor- 
porations, and  which  is  of  considerable  practical  importance, 
concerns  the  propriety  of  capitalizing  initial  losses  and  ex- 
penses. Every  new  corporation  must  expect  to  incur  a  loss 
during  the  period  between  the  time  it  starts  operations  and 
the  time  its  business  is  on  a  normal  basis.     This  period  may 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.  159-162. 


178 


CAPITAL 


be  long  or  short,  depending  upon  the  nature  of  the  business. 
With  many  companies  such  as  railroads,  large  manufacturing 
establishments,  publishing  concerns,  developers  of  urban  real 
estate,  and  the  like,  the  period  is  apt  to  be  several  years  in 
length.  With  trading  companies  the  period  should  be  rela- 
tively short.  The  excess  of  expenditures  over  income  during 
this  period  is  frequently  charged  to  some  capital  account  or 
accounts,  such  as  "Development  Expenses,"  "Organization 
Expenses,"  "Good-Will,"  or  "Deferred  Expenses."  When  a 
business  comes  to  be  on  a  normal  basis  and  is  earning  profits, 
then  initial  expenses  and  losses  may  either  be  written  off  or 
may  be  transferred  to  some  permanent  capital  account,  thus 
providing  a  basis  for  a  later  increase  in  capitalization. 

The  same  question  arises  in  connection  with  interest  pay- 
ments on  bonds  that  have  been  issued  during  the  process  of 
construction  and  development  of  a  company  and  in  connection 
with  discounts  on  bonds  sold  below  par.  In  a  well-known 
English  case  it  was  decided  in  1906  that  "where  a  company 
borrows  money  to  construct  permanent  works  the  interest  paid 
during  the  period  of  construction  might  properly  be  treated  as 
a  part  of  the  cost  of  construction  and  charged  to  capital."* 

The  English  Companies'  Consolidation  Act  of  1908  spe- 
cifically provides  that  where  shares  are  issued  to  defray  ex- 
penses of  construction,  the  company  may  pay  interest  on  such 
shares  and  charge  the  payments, to  capital  accounts,  with  the 
provisos  that  the  payment  be  authorized  by  the  stockholders 
and  by  the  Board  of  Trade;  that  it  shall  not  continue  more 
than  six  months  after  construction  is  complete;  that  the  rate 
of  interest  shall  not  exceed  4%  ;  and  that  the  transaction  be 
clearly  shown  in  the  company's  books  of  account.  In  this 
country  much  the  same  practice  is  found  as  in  England, 
although  it  is  not  so  definitely  authorized. 


*Hines  V.  Buenos  Aires  Grand  National  Tramways,  2  Ch.  654;  quoted  in  Gore* 
Brown  and  Jordan's  handbook  on  "Joint-Stock   Companies,"  p.  283. 


BASIS   OF   CAPITALIZATION 


179 


There  seems  to  be  no  serious  objection  to  be  urged,  al- 
though the  practice  may  sometimes  favor  abuses.  Examples 
might  be  cited  of  companies  which  have  little  or  no  prospect 
of  success  and  yet  have  gone  on  for  a  period  of  four  or  five 
years  charging  the  losses  on  their  normal  operations  to  a  fic- 
titious capital  account,  thus  rendering  a  forced  statement  of 
alleged  profits  to  their  shareholders.  These  isolated  abuses, 
however,  are  hardly  to  be  taken  as  sound  objections  to  a  prac- 
tice which  is  in  itself  correct.  We  are  probably  quite  justified 
in  saying  that  the  total  investment  in  an  enterprise  includes  a 
reasonable  allowance  for  expenses  and  losses  incurred  in  carry- 
ing through  the  initial  organization  and  development. 

Capitalization  of  Earning  Power 

We  have  already  touched  upon  the  fundamental  reasons 
for  regarding  earning  power  as  the  proper  basis  of  capitaliza- 
tion. This  principle  is  generally  accepted  as  correct  in  the 
United  States,  England,  France,  and  other  commercial  coun- 
tries except  Germany,  wherein  the  laws  insist  with  much 
strictness  on  a  close  correspondence  between  capitalization  and 
investment.  Speaking  on  this  point,  Paul  M.  Warburg,  now  a 
member  of  the  Federal  Reserve  Board,  wrote  several  years 
ago: 

Stock-watering,  that  is,  capitalization  of  earning  power 
or  good-will,  is  permitted  in  England  and  France,  while 
it  is  not  allowed  in  Germany.  While  personally  I  prefer 
the  German  system,  it  is  a  mistaken  idea  to  think  that 
the  capitalization  of  earning  power  necessarily  means 
taking  advantage  of  somebody.  If  the  German  sells  at 
200%  an  industrial  stock  paying  10%  dividends,  it 
amounts  to  the  same  as  if  the  Englishman  had  sold  at 
par  twice  the  amount  of  shares  on  which  5%  dividend 
is  paid.* 


*Quoted  from  article  on  "American  and  English  Banking  Methods  Compared,"  by 
il  M. 


Paul  M.  Warburg,  in  North  Americcm  Review^  1908. 


l8o  CAPITAL 

Capitalization  on  the  basis  of  earning  power  is  not  neces- 
isarily  the  result  of  a  carefully  thought-out  plan.  On  the  con- 
trary, it  usually  is  the  by-product  of  an  effort  on  the  part  of 
the  managers  of  corporations  to  make  their  holdings  as  attrac- 
tive as  possible  so  as  to  be  able  to  sell  them  at  the  highest 
possible  price.  It  is  for  this  reason  that  corporations  which 
have  shares  that  are  actively  dealt  in  are  more  generally  capital- 
ized on  an  earning  power  basis  than  are  the  corporations  which 
are  closely  held.  It  has  been  found  through  long  experience 
that  shares  which  sell  at  or  below  par  have  a  readier  market 
and  command  a  higher  price  in»  proportion  to  their  yield  than 
do  shares  which  are  quoted  far  above  par.  If  a  company  is 
showing  earnings  of  40%  on  its  common  stock  but  is  paying 
only  small  dividends,  it  will  be  found  difficult,  in  all  proba- 
bility, to  sell  such  shares  at  a  price  commensurate  with  their 
intrinsic  value.  But,  if  the  same  company  through  some  device 
quadruples  its  capitalization  so  that  the  earnings  on  each  share 
amount  to*  10%,  it  may  safely  be  assumed  that  the  new  shares 
will  sell  for  more  than  25%  of  the  market  price  of  the  old 
shares. 

There  is  very  little,  if  any,  sound  reason  for  the  preference 
generally  shown  for  shares  that  sell  near  or  below  par.  Two 
explanations,  however,  may  be.  offered :  First,  there  is  a  some- 
what wider  market  for  low-priced  shares,  due  to  the  fact  that 
they  are  usually  bought  and  sold  in  lots  of  10  or  more;  it  is 
obvious  that  there  are  more  people  who  can  buy  a  lot  of  10 
shares  worth  $40  each,  than  a  lot  of  10  shares  worth  $400 
each.  Second,  there  is  an  impression  in  the  mind  of  the 
average  shareholder — a  vague  impression  but  powerful — that 
his  stock  either  had  or  wnll  have  a  real  value  about  equivalent 
to  its  par  value.  If  he  buys  below  par,  he  sees  a  prospect,  at 
least,  of  appreciation  in  the  value  of  his  holdings.  This  im- 
pression, we  may  grant  at  once,  is  based  on  a  misconception. 
Many  shareholders  do  not  seem  fully  to  understand  that  their 


BASIS   OF   CAPITALIZATION  l8l 

property  rights  consist,  practically,  only  of  an  equity,  and 
that  the  corporation  is  under  no  obligations  ever  to  return  or 
account  for  the  par  value  of  their  shares.  Nevertheless,  there 
is  an  imaginative  appeal  in  the  magic  term  "$ioo"  stamped  on 
the  face  of  a  stock  certificate,  which  undoubtedly  helps  to  sell 
low-priced  shares. 

The  rate  of  capitalization  of  earning  power  of  a  corpora- 
tion depends  naturally  on  the  corporation's  stability  and  on 
the  nature  of  the  business.  A  railroad  or  public  utility  com- 
pany may  find  stock  which  yields  only  5  to*  7%  selling  at  or 
near  par.  The  shares  of  a  manufacturing  or  trading  com- 
pany must  usually  earn  8  to  12%  or  15%  if  they  are  to  sell 
at  par.  These  percentages  do  not  refer  solely  to  dividends, 
but  to  the  actual  net  earnings  of  the  corporation  after  all  claims 
prior  to  dividends  on*  the* common  stock  have  been  met.  There 
is,  of  course,  no  definite  rule  for  determining  what  percentage 
should  or  will  be  used  in.  working  out  the  capitalization.  That 
must  be  determined  by  observing  the  market  action  of  the 
company's  shares  and  of  other  similar  shares. 

There  is  a  perceptible  tendency,  which  it  is.  interesting  to 
bear  in  mind,  toward  establishing  an  approximate  equality 
between  the  outstanding  capitalization  of  a  company  and  its 
gross  earnings.  Note  that  the  relation  is  with  gross  earnings, 
not  with  net  earnings.  When  the  F.  W.  Woolworth  Company 
(owner  of  the  well  known  chain  of  5  and  10  cent  stores)  was 
incorporated  in  1912,  the  estimated  earning  capacity  was  capi- 
talized at  $50,000,000,  or  over  80%  of  the  entire  capital  stock. 
This  figure  was* almost  equivalent  to  the  company's  gross  sales 
of  the  preceding  year. 

Following  is  a  compilation  showing  the  stocks  and  bonds 
outstanding  in  the  hands  of  the  public,  the  gross  sales,  and 
the  percentage  of  gross  sales  to  outstanding  capitalization  in 
each  case :* 


•Adapted  from  article  in  Wall  Street  Journal,  August  26,  1915. 


l82 


CAPITAL 


Company  Total              Gross 
Capitalization 

General   Motors $39,338,983  $85,373,302 

American  Smelters 158,976,498  200,925,625 

General    Electric 83,885,987      90,467,691 

American    Tobacco 73,139,626      69,339,083 

Westinghouse    46,967,444      33,671,485 

Pressed  Steel  Car 21,866,665      13,375,090 

American   Locomotive 56,702,530      29,987,438 

y.  S.  Steel 1,498,643,673  558,414,933 

Republic  Iron  &  Steel 69,180,414      21,366,249 

Baldwin  Locomotive 48,390,523      13,616,163 


Proportion  of 

Gross  to 
Capitalization 

2.17 
1.26 
1.08 

•95 

.72 

.61 

.53 

.37 

.31 

^8 


It  will  be  noted  that  the  five  companies  at  the  bottom  of 
the  list  above,  had  all  been  going-  through  a  period  of  excep- 
tionally slack  business  when  this  table  was  compiled.  Ordi- 
narily their  gross  would  run  a  great  deal  higher.  Making 
this  allowance,  we  find  only  one  radical  exception  in  the  above 
table  to  the  general  rule  that  capitalization  and  gross  earnings 
tend  toward  an  equality.  This  exception  is  the  General  Motors 
Company,  the  stock  of  which  is  selling  at  a  high  price;  it  is 
rumored  that  this  company  is  likely  to  increase  its  capitaliza- 
tion at  the  first  good  opportunity. 

The  correspondence  applies  chiefly  in  manufacturing  and 
trading  operations  and  not  at  all  in  the  railroad  or  public 
utility  field.  This  may  best  be  shown  by  the  following  tabu- 
lated comparisons  of  capital,  gross  returns,  net  returns,  and 
percentage  of  net  returns  to  capital,  as  shown  by  the  United 
States  Census  returns  for  1900,  1905,  and  1910: 


} 
Manufactujiing  Establishments 


Year 

1900 
1905 
1910 


Year 

1900 

1905 
1910 


Capital 

$8,975,256,000 
12,675,581,000 
18,428,270,000 


Capital 

$10,263,313,000 
11,951,349,000 
14,387,816,000 


Gross  Returns       Net  Returns 


$11,406,927,000 
14,793,903,000 
20,672,052,000 


$1,536,502,000 
1,655,643,000 
2,218,972,000 


Railroads 

Gross  Returns      Net  Returns 


$1,487,045,000 
2,082,482,000 
2,750,667,000 


$477,284,000 
628,406,000 
824,241,000 


Percentage  of 

Net  Returns 

to  Capital 

17 

13 

12 


Percentage  of 

Net  Returns 

to  Capital 

4.7 

5-3 

5.7 


BASIS    OF   CAPITALIZATION 


183 


If  we  assume  that  the  capital  invested  both  in  manufac- 
tories and  in  railroads  is  represented  by  an  approximate  equal 
market  value  of  bonds  and  shares  outstanding — which  is, 
perhaps,  not  far  from  the  truth — then  the  above  figures  give 
us  the  average  rate  of  yield  which  the  investor  in  the  shares 
of  railroad  and  of  manufacturing  companies  may  reasonably 
expect. 

Although  it  is  not  possible  to  secure  exactly  corresponding 
data  for  other  countries,  it  may  be  of  interest  to  compare  the 
above  percentages  with  the  yields  on  capital  invested  in  various 
lines  of  business  in  Germany  for  the  year  1908,  which  were 
as  follows:* 

Banking 7-7% 

Insurance   i9-3% 

Chemical  Industry i5-7% 

Large  Scale  Chemical  Enterprises ii-5% 

Mining,  Smelting,  Salt  Works,  etc. 9-5% 

Textile  Industries 9-4% 

Electrical  Industries    8    % 

Street  Railways 4-3% 

The  average  profits  and  dividends  for  various  lines  of  in- 
dustrials in  Russia  for  191 1  were  as  follows  if 

Average  Average 

Profits  Dividends . 

Mining    13.8%  5.5% 

Textile    13.5%  5.4% 

Credit  Institutions i5-i%  li    % 

Machinery   ii-7%  4-4% 

Foodstuffs    15    %  6.(i% 

Commercial   Concerns i3-i%  7    % 

Chemical  Industries 32-9%  9    % 

Insurance  20.6%  12.2% 

*"The  German  Great  Banks,"  by  Dr.  J.  Riesser,  reprinted  for  the  National  Monetary 
Commission,  Washington,   1911,  p.  464. 

t"Why  Investments  Pay  in  Russia,"  by  Alexander  Znamiecke,  in  The  Americas, 
June,  1915. 


l84  CAPITAL 

The  reason  for  the  correspondence — or  the  tendency 
toward  correspondence — in  the  two  factors  named  above, 
which  at  first  glance  would  be  regarded  as  unrelated,  is  found 
in  the  fact  that  the  percentage  of  net  earnings  to  gross  business 
tends  to  vary  in  inverse  proportion  to  stability  and  in  direct 
proportion  to  the  risk  of  the  business.  This  sounds  like  an 
extremely  abstract  and  difficult  proposition,  though  it  is 
actually  simple  and  practical.  A  company  which  is  running  a 
street  railway  system  is  engaged  in  a  business  that  is  well 
standardized  and  is  subject  to  little  risk  as  to  fluctuation;  con- 
sequently, there  is  a  great  deal  of  competition  or  potential 
competition  among  capitalists  who  are  willing  to  put  their 
money  into  the  business,  and  the  ratio  of  profits  to  gross 
earnings  is  reduced  to  a  small  percentage.  On  the  other  hand, 
the  business  of  manufacturing  a  novelty  which  may  quickly  be 
displaced  is  risky,  and  capital  will  be  invested  only  by  persons 
who  are  experienced  in  the  business.  For  both  these  reasons, 
the  ratio  of  profits  to  earnings  or  sales  must  be  exceptionally 
high  in  order  to  attract  sufficient  capital.  The  same  factors 
precisely  are  at  work  in  determining  how  large  earnings  must 
be  in  order  to  make  the  shares  of  various  companies  command 
a  market  price  not  far  removed  from  their  nominal  value. 
The  percentage  of  net  profit  on  sales,  and  the  percentage  of 
yield  on  investments  in  the  company's  shares,  will  be  about 
the  same.  Hence,  it  necessarily  follows  that  capitalization 
tends  to  adapt  itself  and  to  become  equal  to  gross  business.  It 
is  perhaps  unnecessary  to  repeat  that  this  is  only  a  tendency 
and  by  no  means  an  invariable  rule. 

Many  examples  of  the  adjustment  of  capitalization  to 
earnings  might  be  cited;  indeed,  almost  any  large  industrial  I 
corporation,  the  shares  of  which  are  w^idely  traded  in,  would 
serve  this  purpose.  At  its  reorganization,  the  United  States 
Realty  and  Construction  Company  had  tangible  property  worth 
approximately   $11,000,000,    and   cash   amounting   to   about 


BASIS    OF   CAPITALIZATION  185 

$11,000,000,  against  which  was  issued  $27,500,000  in  pre- 
ferred stock  and  $33,500,000  in  common  stock;  $61,000,000 
in  all.  The  earning  power  of  the  two  companies  which  had 
been  combined  amounted,  however,  to  about  $3,500,000,  and 
there  was  thought  to  be  reasonably  good  prospects  for  growth 
in  these  earnings.  On  the  strength  of  these  earnings  the  capi- 
talization was  regarded  as  perhaps  somewhat  excessive  but 
not  abnormal.  As  a  matter  of  fact,  the  company  later  failed 
disastrously,  due  in  part  to  the  overestimates  that  had  been 
made  of  its  earning  capacity. 

A  striking  example  of  sudden  variation  in  earnings  quickly 
followed  by  readjustment  of  capital  is  furnished  by  the  Sub- 
marine Boat  Corporation.  This  corporation  was  originally 
known  as  the  Electric  Boat  Company,  and  for  many  years  was 
regarded  as  practically  a  failure.  It  had  an  authorized  capital 
of  $5,000,000  common  and  $5,000,000  preferred,  of  which 
$4,999,600  common  and  $2,667,500  preferred  were  outstand- 
ing. The  company's  business  was  to  build  submarines  for 
which  it  held  valuable  patents,  and  also  high-powered  gasoline 
launches  which  may  be  used  as  submarine  destroyers.  After 
it  appeared  that  the  submarine  was  to  become  a  highly  im- 
portant factor  in  the  European  conflict,  it  quickly  became 
evident  that  the  Electric  Boat  Company  was  in  a  position  to 
reap  enormous  profits  from  the  situation.  As  late  as  the  winter 
of  1 91 4,  the  common  stock  was  quoted  at  a  nominal  price, 
around  $10  a  share;  by  the  fall  of  191 5  it  had  risen  to  over 
$480  a  share.  During  this  rise,  Isaac  L.  Rice,  the  organizer 
and  long  the  chief  manager  of  the  company,  sold  his  shares, 
which  were  taken  over  by  a  syndicate  that  arranged  to  recapi- 
talize and  for  this  purpose  formed  the  Submarine  Boat 
Corporation. 

The  shares  of  stock  of  the  new  corporation  were  issued 
without  par  value  and  for  this  reason  it  is  impossible  to 
cite  exact  figures  showing  the  extent  of  the  recapitalization. 


l86  CAPITAL 

However,  on  the  basis  of  the  quoted  boat  shares,  the  new 
capitaHzation  of  the  Submarine  Boat  Corporation  may  be 
figured  as  having  a  market  value  at  the  beginning  of  $35,- 
000,000. 

There  is  surely  little  doubt  in  the  mind  of  any  one  who 
is  familiar  with  such  occurrences,  as  to  the  truth  of  the  general 
statement  that  capitalization  tends  very  strongly  to  conform 
itself  to  earnings  rather  than  to  actual  investment. 

Estimates  of  Earning  Power 

In  what  has  been  said  in  the  preceding  section  as  to  adapt- 
ing capitalization  to  earning  power,  it  has  been  assumed  that 
there  will  be  no  difficulty  in  determining  earnings.  If  a  com- 
pany has  been  doing  business  successfully  over  a  period  of 
years  and  has  had  reasonably  stable  earnings,  it  would  seem 
that  there  ought  to  be  little  difficulty  in  estimating  the  proba- 
bilities for  the  future;  yet  the  experience  gained  during  the 
last  15  or  20  years  in  forming  combinations  of  industrial  com- 
panies indicates  quite  clearly  that  even  expert  estimates  are 
an  unsafe  guide. 

At  the  time  the  American  Malting  Corporation  was  formed 
in  1897,  a  preliminary  examination  of  the  22  plants  concerned 
was  made  by  an  accountant  of  high  standing,  who  reported 
that  these  concerns  had  earned  about  $1,300,000  per  annum 
during  five  years  of  depression,  and  that  the  net  earnings 
under  a  combination  should  be  at  least  $2,000,000  without 
raising  the  price  of  the  product  to  the  consumers.  Unfor- 
tunately, in  making  this  estimate  one  important  factor  was 
overlooked.  The  business  of  furnishing  malt  to  brewers  had 
been  an  affair  largely  of  financial  connections  and  personal 
friendships.  The  brewers  preferred  to  deal  direct  with  the 
heads  of  the  concerns  from  whom  they  bought  their  malt  and 
refused  to  take  kindly  to  the  more  businesslike  methods  of 
the  "trust."    As  a  result,  the  combination,  instead  of  gaining 


BASIS    OF   CAPITALIZATION  187 

through  the  greater  efficiency  of  its  sales  methods,  actually 
lost  ground.  The  whole  transaction,  it  has  been  remarked,  is 
"a  startling  illustration  of  the  fallacy  of  basing  an  estimate 
of  the  future  earnings  of  a  consolidated  company  upon  the 
aggregate  earnings  of  the  constituent  plants  prior  to  their 
combination."* 

In  his  excellent  study,  which  is  frequently  referred  to  in 
this  volume,  Mr.  Dewing  includes  a  list  of  important  indus- 
trial combinations  showing  the  ratio  between  the  earnings 
actually  realized  after  the  consolidation,  and  the  aggregate 
earnings  of  the  subsidiary  companies  before  the  combination. 
The  following  are  his  percentages: 

Mount  Vernon- Woodberry  Cotton  Duck  Company  166% 

National  Salt  Company I34% 

New  England  Cotton  Yarn  Company 98% 

International  Cotton  Mills  Corporation 56% 

United  States  Ship  Building  Company 56% 

United  States  Realty  &  Construction  Co 50% 

Asphalt  Company  of  America 40% 

American   Malting  Company 31% 

American  Bicycle  Company 24% 

Some  of  the  discrepancies  above  shown  may  have  been 
due  in  part  to  padded  statements  of  earnings  on  the  part  of 
the  companies  which  just  prior  to  the  combination  were  trying 
to  make  the  best  possible  terms  for  themselves,  and  some  are 
due,  doubtless,  to  the  fact  that  combinations  are  generally 
organized  at  the  height  of  a  period  of  prosperity.  In  general, 
however,  they  seem  to  represent  a  tendency  toward  actual 
decline  in  efficiency  under  the  new  form  of  organization. 

Wherever  the  personal  element  in  management  is  strong, 
estimates  of  future  earnings  are  particularly  uncertain.  After 
a  strong,  going  organization  has  been  formed  and  methods 
have  become  standardized,  this  element  of  uncertainty  due  to 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  p.  273. 


l88  CAPITAL 

the  personal  factor  becomes  less  and  less  prominent.  Never- 
theless, in  some  lines  of  business  it  is  especially  strong.  For 
example,  it  is  reported  that  bankers  are  not  willing  to  make 
large  advances  to  companies  engaged  in  operating  chain  stores. 
They  believe  that  these  stores  depend  to  an  especial  degree 
upon  the  human  equation.  A  single  mistake  in  buying  on  a 
large  scale  might  result  in  serious  loss,  for  these  stores  gen- 
erally sell  on  a  close  margin  of  profit.  The  death  of  the 
executive  who  had  built  it  up  and  had  formed  his  personal 
connections  might  be  a  fatal  blow. 

Another  source  of  uncertainty  In  lines  of  business  where 
earnings  would  otherwise  be  remarkably  stable,  consists  in 
the  legislating  power  of  governmental  bodies.  The  legisla- 
tures of  several  states  have  in  recent  years  passed  laws  fixing 
rates  of  transportation  and  of  public  utility  services  on  arbi- 
trary bases  which  have  introduced  a  sudden  and  wholly  un- 
foreseeable change  in  the  earnings  of  the  corporations  affected. 
There  is  probably  no  reasonable  ground  for  doubting  that 
this  is  a  wrong  principle.  Wherever  profits  require  regula- 
tion, it  should  certainly  be  carried  on  by  some  systematic  and 
continuous  method.  In  Great  Britain  there  is  no  such  thing 
as  public  rate  regulation  as  understood  in  America.  The  two 
methods  of  regulation  are  the  maximum  dividend  method  and 
the  sliding  scale  method,  both  of  which  operate  continuously 
and  automatically. 

There  is,  perhaps,  no  safe  practical  rule  to  follow  in  mak- 
ing or  in  reviewing  estimates  of  future  earnings,  except  to 
follow  the  rule  of  skepticism.  Sometimes  the  skepticism  may 
be  undeserved,  but  at  any  rate  the  banker  or  investor  can  make 
no  mistake  in  demanding  full  and  satisfactory  evidence  of  the 
correctness  of  the  estimates.  This  remark  applies  especially 
to  promoters'  estimates  of  the  future  profits  of  their  concerns. 
"When  you  are  capitalizing  a  perhaps  which  you  believe  to 
be  infinite,"   says   Hartley  Withers  in   one   of  his  incisive 


BASIS   OF  CAPITALIZATION  189 

epigrams,  "the  number  of  noughts  that  you  add  on  to  the 
market  vakie  of  the  company's  capital  is  a  matter  that  does 
not  concern  you  as  long  as  you  are  wrought  up  to  the  right 
pitch  of  excitement."* 

Adjusting  Capitalization  to  Assets 

It  is  plain,  from  what  has  been  said  above  that  many 
corporations,  either  at  the  outset  or  at  some  later  stage  in 
their  career,  are  faced  with  wide  discrepancy  between  the 
actual  value  of  all  their  assets  and  the  nominal  net  worth  of 
the  business  which  is  represented  by  capital  stock.  In  1897, 
for  example,  the  Glucose  Sugar  Refining  Company  was  or- 
ganized as  a  combination  of  six  glucose  refineries.  Although 
$7,500,000,  it  is  reliably  estimated,  would  have  fully  covered 
the  actual  value  of  the  plants  and  current  assets  acquired,  the 
company  started  with  a  capital  stock  issue  of  $37,000,000.  In 
1906  this  same  combination,  with  some  additions,  was  reor- 
ganized under  the  name  of  the  Corn  Products  Refining  Com- 
pany, which  is  estimated  to  have  had  assets  worth  approxi- 
mately $15,000,000.  Against  these  assets  the  company  issued 
a  bonded  debt  of  $9,500,000,  preferred  stock  of  $30,000,000, 
and  common  stock  of  $50,000,000. 

Once  in  a  while,  if  a  corporation  has  been  continually 
unsuccessful  over  a  period  of  years,  an  effort  is  made  to 
improve  the  financial  status  by  reducing  its  capital  stock  and 
its  contingent  charges.  This  was  attempted,  for  example,  with 
the  Corn  Products  Refining  Company  in  19 10,  when  the  presi-. 
dent  brought  out  a  plan  which  called  for  the  absolute  sur- 
render and  cancellation  of  four-fifths  of  the  outstanding  $50,- 
000,000  of  common  stock;  the  remaining  one-fifth  of  common 
and  all  the  preferred  stock  was  to  be  exchanged  for  new  stock 
of  one  class,  upon  which  it  was  proposed  to  pay  dividends 
at  the  rate  of  5%  per  year.     The  result  would  have  been  to 

♦Hartley  Withers  on  "Stocks  and  Shares,"  p.  287. 


190 


CAPITAL 


cut  down  the  charges  against  the  company  and  to  make  up 
a  much  better-looking  balance  sheet.  However,  the  preferred 
stockholders  saw  no  advantage  to  themselves  in  giving  up  part 
of  their  claims  and  the  plan  eventually  failed. 

A  similar  process  is  much  more  frequent  in  English  prac- 
tice. In  November,  19 14,  a  circular  letter  was  sent  out  to  the 
preference  shareholders  of  R.  White  and  Sons,  in  which  the 
directors  stated  that  they  had  had  fresh  valuations  made  of 
the  assets  which  had  disclosed  a  total  value  less  than  the  book 
value  of  these  assets,  amounting  to  £87,760.  The  directors 
were  also  anxious  to  eliminate  from  the  balance  sheet  the 
large  "good-will"  item  which  amounted  to  £94,367,  and 
thought  it  wise  to  write  off  a  further  sum  of  £7,500  against 
other  assets.  These  three  sums  together  amounted  to  £189,- 
627.  The  directors'  proposal  was  to  charge  £25,627  against 
Reserves  and  Profit  and  Loss  accounts,  leaving  £164,000  still 
to  be  dealt  with.  This  was  offset  by  reducing  the  nominal 
value  of  all  the  outstanding  ordinary  shares  from  £3  to  £1 
each.  The  ordinary  shareholders  made  it  a  condition  of  their 
agreement  to  this  arrangement,  that  they  should  be  entitled 
to  the  same  aggregate  amount  of  dividends  on  their  shares 
as  they  were  previously  entitled  to  before  contributions  were 
made  to  the  special  reserve.  That  is  to  say,  where  they  were 
previously  entitled  to  5%,  they  were,  after  the  change,  en- 
titled to  15%  on  the  reduced  capitalization. 

To  the  average  American  mind  all  the  complexities  and 
niceties  of  a  transaction  such  as  the  one  just  described,  seem 
like  so  much  useless  juggling  with  figures.  The  purpose  of 
any  well-managed  company  is  to  make  profits  and  distribute 
them  according  to  the  various  claims  against  these  profits  that 
are  outstanding.  Whether  the  ordinary  stock  Is  listed  at  a 
nominal  value  of  $82,000  or  $246,000;  whether  "good-will" 
stands  at  $94,000  or  at  nothing,  and  similar  questions  of 
academic  accounting,  have  very  little  apparent  connection  with 


BASIS   OF  CAPITALIZATION  191 

changing  the  business  from  a  profit-loser  into  a  profit-maker. 
The  typical  English  financial  manager  attaches  vastly  more 
importance  than  does  the  typical  American  financial  manager, 
to  presenting  a  balance  sheet  that  makes  an  impression  of 
stability  and  conservatism.  Doubtless  there  is  much  to  be 
said  on  both  sides.  It  is  enough  here  merely  to  call  attention 
to  the  variation  in  practice. 

It  is  sometimes  thought  to  be  desirable  by  the  directors  of 
a  corporation  to  have  the  corporation  purchase  some  of  its 
own  outstanding  stock,  which  is,  in  effect,  a  method  of  reduc- 
ing its  capitalization.  The  general  rule  of  the  law,  which 
applies  with  modifications  in  almost  all  jurisdictions,  is  to  the 
effect  that  a  corporation  may  purchase  its  own  shares  only 
out  of  surplus.  It  cannot,  in  other  words,  carry  the  purchase 
of  its  own  shares  so  far  as  to  produce  a  deficit  which  might 
be  injurious  to  creditors. 

Valuation  of  Good-will 

The  law  assumes  that  the  assets  of  a  corporation  are  valued 
at  cost  and  that,  after  the  deduction  of  liabilities,  the  remain- 
ing equity  in  the  assets  is  represented  by  capital  stock. 

The  truth  of  the  case  is,  as  we  have  seen,  that  capitaliza- 
tion— at  least  for  the  companies  with  marketable  securities — 
is  determined  on  the  basis  of  earning  power,  and  that  the 
book  valuation  of  a  company's  assets  is  then  adjusted  to  the 
capitalization.  This  makes  the  valuation  of  assets  for  account- 
ing purposes,  in  part  at  least,  an  arbitrary  process.  Whenever 
it  is  not  thought  desirable  to  place  a  purely  arbitrary  value 
upon  tangible  assets,  or  whenever  the  capitalization  is  so  large 
that  any  arbitrary  value  within  reason  will  still  leave  a  gap, 
then  we  have  "Patents,"  "Copyrights,"  "Organization," 
"Good-will,"  or  some  other  intangible  asset  entered  upon  the 
books  and  appearing  in  the  balance  sheet  at  a  valuation  suffi- 
cient to  offset  the  nominal  value  of  outstanding  capital  stock. 


192 


CAPITAL 


As  an  illustration,  take  a  case,  which  came  to  the  writer's 
attention  some  years  ago,  of  a  company  publishing  a  well- 
known  popular  magazine,  which  had  issued  stock  only  for  an 
equivalent  amount  of  cash  paid  in.  The  magazine  had  out- 
standing $300,000  of  common  stock;  had  assets  over  and 
above  the  liabilities  (except  stock)  of  approximately  $250,000; 
and  showed  also  on  the  asset  side  of  the  balance  sheet  an 
accumulated  deficit  of  practically  $50,000.  Its  balance  sheet 
in  this  highly  condensed  and  simplified  form  would  appear 
as  follows: 


Assets 

Net  Capital  and  Current 

Assets   $250,000.00 

Accumulated  Deficit....       50,000.00 


Total   $300,000.00 


Liabilities 
Capital  Stock $300,000.00 


$300,000.00 


Just  about  the  time  when  the  magazine  had  reached  this 
stage  and  its  proprietors  were  greatly  discouraged,  it  started 
to  run  a  series  of  feature  articles  which  suddenly  became 
immensely  popular.  The  circulation  and  advertising  receipts 
suddenly  jumped  to  figures  previously  unthought  of.  In  the 
first  year  after  this  sudden  change  of  fortune,  the  corporation 
earned  profits  of  approximately  $40,000,  and  the  directors 
desired  to  distribute  dividends  of  $30,000.  But  there  was  no 
surplus  out  of  which  to  declare  dividends;  on  the  contrary, 
the  balance  sheet  still  showed  an  impairment  of  capital  which 
must  be  made  up  before  dividends  could  legally  be  declared. 
In  this  predicament  they  called  in  an  experienced  accountant 
who  solved  the  difficulty  by  directing  that  a  very  simple  entry 
be  put  into  the  company's  journal,  debiting  a  new  account  to 
be  called  "Good-will"  to  the  amount  of  $100,000  and  crediting 
Surplus  for  a  like  amount.  Thereafter  the  company's  balance 
sheet  in  its  highly  simplified  form,  appeared  as  follows: 


BASIS   OF  CAPITALIZATION 


193 


Assets 

Net  Capital  and  Current 

Assets   $290,000.00 

Good- will  100,000.00 

Liabilities 

Capital  Stock. $300,000.00 

Surplus  90,000.00 

Total  $390,000.00 

$390,000.00 

There  was  then  nothing  to  prevent  the  immediate  distribu- 
tion of  cash  profits  in  the  form  of  dividends.* 

Good-will  is  not  necessarily  valued  in  quite  so  arbitrary 
and  casual  a  fashion.  Where  a  corporation  has  accumulated 
out  of  earnings  a  substantial  surplus,  and  where  there  is  gen- 
uine good-will  which  it  is  desirable  to  show  in  one  form  or 
another  in  the  balance  sheet,  a  careful  valuation  may  be  made. 
For  example,  a  case  of  this  nature  arose  in  connection  with 
the  appraisal  in  September,  19 14,  of  the  estate  of  the  late 
Joseph  Pulitzer,  former  proprietor  of  the  New  York  World 
and  of  the  St.  Louis  Post-Despatch.  The  appraiser,  first  of 
all,  made  a  careful  estimate  of  the  earning  power  of  each  one 
of  the  newspaper  properties.  For  this  purpose  he  took  the 
average  annual  earnings  of  each  corporation  for  four  years 
preceding  Mr.  Pulitzer's  death.  From  this  average  figure, 
however,  he  deducted  a  considerable  sum  by  reason  of  certain 
very  favorable  contracts  for  the  purchase  of  white  print  paper 
which  were  about  to  expire,  and  he  further  deducted  $100,000 
as  being  a  reasonable  estimate  of  the  value  of  the  services  of 
Mr.  Pulitzer  himself.  He  deducted,  also,  6%  on  the  actual 
capital  invested.  This  left  average  net  earnings  of  $196,411 
for  the  .S'^.  Louis  Post-Despatch,  and  $81,180  for  the  New 
York  World,  both  of  which  the  appraiser  capitalized  on  a 
10%  basis,  making  his  valuation  of  the  good-will  of  the  first- 
named  paper  $1,964,110,  and  of  the  second-named  paper, 
$811,800. 


*The  case  just  cited  is  actual  but  the  figures  have  been  much  changed  in  order 
to  simplify  the  statement  and  to  avoid  identification. 


194  CAPITAL 

The  above  case  is  one  of  the  most  important  precedents 
for  methods  of  valuing  good- will  that  have  been  established 
in  this  country.  In  England  it  is  customary  to  calculate  the 
good- will  as  the  present  worth  of  the  profits  from  three  to 
ten  years  ahead,  the  length  of  time  depending  upon  the  sta- 
bility and  transferability  of  the  business. 

The  following  remarks  on  this  point  were  made  by  the 
v/riter  in  connection  with  an  inquiry  as  to  how  to  determine 
the  value  of  an  insurance  agency  business : 

Having  arrived  at  the  value  of  all  the  other  assets 
of  an  insurance  agency,  i.e.,  furniture  and  fixtures, 
insurance  in  force,  real  estate,  etc.,  it  would  then  be  neces- 
sary to  estimate  the  worth  of  its  insurance  business  itself. 
The  personal  equation  plays  a  great  share  in  agency 
insurance,  and  the  withdrawal  of  the  man  or  men  who 
have  been  actively  identified  with  the  establishment  and 
with  the  running  of  the  agency  is  likely  to  affect  seriously 
the  earnings  of  the  concern,  especially  if  the  business 
has  been  confined  to  a  particular  locality,  which  is  often 
the  case.  There  is  also  to  be  considered  the  value  which 
attaches  to  its  sub-agency  force  as  well  as  the  volume 
of  business  the  agency  is  doing,  since  the  rates  of  com- 
mission paid  by  the  insurance  companies  and  the  credits 
extended  by  them  in  the  collection  of  premiums  are  by 
no  means  uniform.  An  additional  point  tc  be  considered 
is  that  in  many  instances  insurance  agents  also  act  in 
the  capacity  of  adjusters  in  fixing  losses  of  their  clients. 
The  earnings  from  this  source  are  often  not  to  be  found 
on  the  books  of  insurance  agents,  and  it  is  an  item  to 
be  considered. 

Having  in  mind  all  these  factors,  the  test  to  be  applied 
in  determining  the  worth  of  the  business  itself  is: 
How  much  earning  power  could  be  transferred  to  other 
individuals  who  might  take  over  the  business  ?  Capitalize 
this  earning  power  at  whatever  rate  is  agreed  upon,  say 
15%,  and  you  have  the  transferable  good- will  of  the 
business. 


BASIS   OF   CAPITALIZATION 


195 


In  this  discussion,  no  attempt  has  so  far  been  made  to 
give  an  accurate  definition  of  the  vague  term  "good-will." 
It  is,  in  fact,  almost  incapable  of  definition  for  the  reason  that 
it  is  continually  used  in  many  varying  senses.  The  term  arose 
undoubtedly  in  connection  with  retail  trade  and  with  profes- 
sional practice,  where  it  referred  to  the  habit  that  had  been 
established  on  the  part  of  many  people  who  were  accustomed 
to  trading  with  a  good  shop  or  with  an  established  profes- 
sional practitioner.  Experience  has  shown  that  this  habit  will 
continue  to  carry  people  to  a  shop  or  to  a  physician's  or 
lawyer's  office  even  after  the  original  proprietor  or  practitioner 
has  withdrawn.  The  vendor  of  a  business  or  a  practice  of 
this  nature  usually  contracted,  for  a  given  consideration,  to 
recommend  his  successor  and  thus  literally  sold  to /him  his 
"good-will."  As  it  is  used  in  a  great  majority  of  present-day 
transactions,  the  term  has  little  perceptible  relation  to  its 
original  meaning.* 

When  a  modern  corporation  transfers  good- will  or  enters 
good-will  upon  its  books,  the  asset  which  is  thus  represented 
consists  of  something  even  more  intangible  than  the  kind  of 
good- will  that  accompanied  the  sale  of  the  little  retail  shop. 
A  corporation's  "good-will"  may  consist  in  part  of  established 
trade  and  of  the  habits  of  people  who  desire  to  buy  its  prod- 
ucts; it  may  consist  in  part  of  having  created  an  efficient, 
smoothly  working  internal  organization;  it  may  consist  in 
part  of  having  driven  off  all  rivals  and  monopolized  its  field; 
it  may  consist  in  part  of  well-known  trade-marks  or  of 
patents.  An  adequate  definition  of  "good- will"  in  its  modem 
sense  must  cover  all  the  above  and  many  other  similar  varia- 
tions of  intangible  assets.  The  one  definition  which  seems  to 
the  writer  to  cover  everything  is  this :    Good-will  is  the  capi- 

*The  classical  definition  of  good-will,  according  to  Withers,  was  contributed  by  Dr. 
Johnson,  when,  as  executor  of  a  friend's  estate,  he  assisted  at  the  sale  of  a  brewery 
to  two  Quaker  gentlemen.  Being  asked  to  place  a  value  on  the  real  assets,  he  replied: 
"We  are  not  here  to  sell  a  parcel  of  boilers  or  vats,  but  the  potentiality  of  growing  rick 
beyond  the  dreams  of  avarice." 


196 


CAPITAL 


talization  of  that  portion  of  the  earning  power  of  a  business 
which  is  not  credited  to  other  assets. 

With  this  definition  in  mind,  the  question  as  to  the  right 
method  of  valuation  of  "good-will"  in  any  given  case  is  sim- 
plified. It  is  necessary  to  follow  the  same  method  that  wab 
used  by  the  appraiser  of  the  Pulitzer  properties,  that  is,  to 
eliminate  from  average  earnings  those  which  are  to  be  ascribed 
to  the  ownership  of  tangible  assets  or  to  temporary  causes; 
the  remaining  earning  power  may  then  be  capitalized  on  what- 
ever basis  is  suitable  for  the  business  under  consideration. 
In  some  lines  of  business  this  percentage  might  be  as  low  as 
6  or  8%  ;  in  others  10%,  and  in  others  12,  15,  and  even  20%. 

The  definition  just  suggested  carries  with  it  a  ready  ex- 
planation of  the  fact  that  "good- will"  is  a  much  more  per- 
manent asset  in  some  lines  of  business  than  in  others.  Those 
lines  of  business  which  employ  an  overwhelming  proportion  of 
fixed  capital  assets,  ordinarily  attribute  their  earnings  almost 
wholly  to  these  assets,  and  there  is  seldom  any  occasion  for 
entering  such  an  item  as  good-will.  On  the  other  hand,  those 
corporations  that  are  engaged  chiefly  in  trading,  their  earnings 
being  dependent  to  a  great  extent  upon  the  rapidity  of  their 
turnover  or  upon  popular  favor,  may  find,  if  they  are  suc- 
cessful, that  their  earnings  mount  far  beyond  any  sum  that 
can  reasonably  be  attributed  to  their  capital  assets. 

In  this  latter  class  belong  such  concerns  as  the  F.  W.  Wool- 
worth  Company,  with  its  great  chain  of  5  and  lo-cent  stores, 
which  carries  a  Good-will  account  of  $50,000,000.  Many 
publishing  companies  quite  properly  carry  good-will  as  one  of 
their  most  important  assets.  The  Butterick  Company,  out 
of  total  assets  of  $19,236,467,  has  $9,786,065,  or  over  one- 
half,  included  under  the  heading  "Patents,  Good-will,  Con- 
tracts, Copyrights,  Trade-marks,  etc."  Messrs.  Silver-Burdett 
and  Company  carry  "Publishing  Rights,  Contracts,  Copy- 
rights, etc.,"  at  $1,024,820  out  of  total  assets  of  $1,944,665. 


005. 


BASIS   OF   CAPITALIZATION  197 

There  are  many  cases,  also,  where  highly  profitable  and  rapidly 
growing  companies  may  have  trouble  in  valuing  their  assets 
at  a  figure  high  enough  to  offset  the  amount  of  stock  which 
their  directors  feel  should  properly  be  outstanding.  This  is 
the  case,  for  instance,  with  the  Hendee  Manufacturing  Com- 
pany of  Springfield,  Mass.,  which  on  August  31,  19 14,  carried 
a  Good-will  account  of  $8,300,000  out  of  total  assets  of  $13,- 
367,502.  The  American  Chicle  Company  carries  "Good- will, 
Trade-marks,  etc.,"  at  $8,128,607  out  of  total  assets  of  $13,- 
592,997.  In  spite  of  this  enlarged  capitalization,  the  company 
has  paid  18%  dividends  on  its  common  stock  regularly  since 
1907.  On  the  other  hand,  the  highly  successful  and  long- 
established  Eastman  Kodak  Company,  which  is  paying  div- 
idends that  average  over  40%,  and  is  earning  in  the  neighbor- 
hood of  70%  on  common  stock,  does  not  carry  a  cent  of 
good-will  or  other  intangible  asset  accounts. 

Recapitalization  by  Stock  Dividends 

In  cases  where  surplus  has  accumulated  with  great  rapidity, 
it  is  more  and  more  customary  for  the  corporation  to  recognize 
this  accumulation  by  issuing  new  shares  in  the  form  of  stock 
dividends.  As  has  been  previously  explained,  this  procedure 
does  not  necessarily  mean  increased  cash  returns  to  the  stock- 
holders and  does  not  affect  their  relative  interests  in  the  cor- 
poration, but  it  is  convenient  and  helps  to  increase  the  market 
value  of  the  stock.  In  recent  years,  some  of  the  motor  com- 
panies which  have  been  highly  successful  have  declared  no- 
table stock  dividends.  The  Chalmers  Company,  for  example, 
was  incorporated  in  1908  with  a  capital  stock  of  $300,000; 
two  years  later  the  directors  declared  a  stock  dividend  of 
900%,  making  the  capital  stock  $3,000,000.  In  October,  1912, 
they  declared  another  stock  dividend  of  33  1/3  %,  making  tht 
outstanding  common  stock  $4,000,000;  and  in  June,  191 3, 
another  dividend  of  25%  was  declared,  making  the  outstand- 


198  CAPITAL 

ing  stock  $5,000,000.  Since  June  i,  191 1,  cash  dividends  on 
the  common  stock  have  been  paid  at  the  rate  of  10%.  In 
191 5  the  Ford  Motor  Company  was  said  to  have  had  under 
consideration  a  stock  dividend  of  2400%,  increasing  its  out- 
standing capital  stock  from  $2,000,000  to  $50,000,000,  but  on 
account  of  some  legal  difficulties  the  plan,  up  to  this  writing, 
has  not  been  carried  through. 

Other  manufacturing  companies  have  also  had  remarkable 
stock  dividend  records.  Up  to  1900  the  capital  stock  of  the 
Singer  Manufacturing  Company  was  $10,000,000,  and  that 
year  a  stock  dividend  of  200%  was  declared,  making  it  $30,- 
000,000.  In  19 10  another  stock  dividend  of  100%  was  de- 
clared, making  the  capital  $60,000,000.  During  all  this  period 
cash  dividends  have  been  high.  In  1899,  just  before  the 
first-named  stock  dividend,  cash  dividends  were  100%  ;  in 
1904  and  again  in  1909  they  were  as  high  as  30%  ;  since  the 
stock  advance  of  19 10  they  have  been  averaging  12  to  14%. 
Swift  and  Company  originally  had  a  nominal  capital  of  $300,- 
000,  which  has  been  increased  at  various  times  to  $3,000,000, 
$5,000,000,  $7,500,000,  $15,000,000,  $20,000,000,  $25,- 
000,000,  $35,000,000,  $50,000,000,  $60,000,000,  and  finally 
$75,000,000. 

Attention  has  already  been  called  to  the  possibility  of 
avoiding  constant  changes  in  capitalization — which  are  always 
of  an  arbitrary  nature — by  the  use  of  shares  without  par  value. 
It  would  be  theoretically  possible  to  have  no  shares  whatever 
outstanding,  and  there  is  one  case  on  record  of  an  English 
enterprise  known  as  the  Undertakers  of  the  Aire  and  Calder 
Navigation  and  Steamship  Company,  which  until  1895  had 
no  shares.  The  capital  was  bought  and  sold  at  so  many  years' 
purchase  of  the  dividends.  The  modern  arrangement,  how- 
ever, is  to  have  shares  bearing  no  par  value.  A  law  authoriz- 
ing the  issue  of  shares  without  par  value  was  adopted  in  New 
York  State  in  1912. 


BASIS   OF   CAPITALIZATION  igg 

Capitalization  of  Public  Service  Companies 

The  assumption  which  has  been  made  throughout  this 
chapter  that  capitalization  may  be  rightfully  adjusted  to  what- 
ever figure  within  reason  the  organizers  or  directors  of  a 
corporation  may  think  proper,  applies  to  manufacturing  and 
trading  companies*,  but  does  not  apply  to  financial  companies 
or  to  most  public  utility  companies.  Financial  companies  are 
in  this  respect  in  a  class  by  themselves,  for  the  reason  that 
they  are  themselves  dealers  in  cash  and  in  credit  and  it  is 
essential  that  their  financial  position  should  be  at  all  times 
clear  and  easily  ascertainable ;  consequently,  they  do  not  enter 
good-will  on  their  accounts,  not  because  it  does  not  frequently 
exist,  but  because  to  do  so  would  involve  questions  of  judg- 
ment and  of  motive  which  they  cannot  afford  to  have  raised. 
For  that  reason  their  balance  sheets  ordinarily  show  only 
assets  the  value  of  which  can  readily  be  determined  by  ex- 
amination, and  as  to  which  no  debatable  question  is  likely  to 
arise. 

The  case  with  public  utility  companies  differs  because  of 
public  sentiment  which  has  been  aroused  against  "overcapi- 
talization," which  is  believed  by  many  people  to  be  injurious. 
In  this  respect  the  English  practice  is  even  more  severe  than 
in  this  country.  The  policy  of  Parliament  and  also  of  the 
Board  of  Trade  of  the  United  Kingdom  has  been  to  grant 
power  to  railway  and  tramway  companies  to  raise  an  amount 
of  capital  estimated  to  be  sufficient  for  their  immediate  re- 
quirements; in  granting  capital  powers  to  gas  companies,  the 
Board  of  Trade  usually  endeavors  to  estimate  the  require- 
ments of  the  company  for  a  term  of  12  to  15  years.  It  is 
clear  that  the  intention  is  to  maintain  a  strict  governmental 
control  and  to  see  to  it  that  every  cent  of  capital  is  represented 
by  a  corresponding  amount  of  cash  or  of  assets  purchased 
with  the  shareholders'  cash.  In  the  United  States,  public 
service  commissions  are  following  much  the  same  policy.    In 


200  CAPITAL 

New  York  State  the  output  of  stocks  and  bonds  by  utility 
corporations  is  carefully  regulated  to  such  an  extent  that  it 
has  proved  really  a  difficult  matter  in  some  instances  to  secure 
permission  to  obtain  capital  that  was  urgently  needed.  For 
some  years  there  has  been  agitation  to  apply  the  same  prin- 
ciples of  regulation  to  interstate  railroads,  but  no  definite 
action  has  as  yet  been  taken. 

We  may  conclude,  then,  that  in  general  the  capitalization 
of  public  utility  companies  is  more  strictly  in  accord  with  the 
legal  theory  of  a  correspondence  between  capitalization  and 
capital  assets  than  is  true  in  other  forms  of  enterprise.  Public 
utility  companies  are  among  the  enterprises  above  referred  to, 
the  earnings  of  which  can  generally  be  attributed  almost 
wholly  to  their  tangible  assets.  As  a  practical  matter,  there- 
fore, it  is  not  inconsistent  with  the  practice  of  most  of  the 
well-managed  companies  to  require  that  they  should  issue 
capital  stock  only  for  the  purpose  of  acquiring  cash  or  tangible 
assets  fully  equivalent  to  the  nominal  value  of  the  stock. 


Part  III — Securing  Capital 


k 


CHAPTER    IX 

SOURCES  OF  CAPITAL  FUNDS 

Capital  Funds 

The  typical  corporation  starts  in  much  the  same  way  as 
the  typical  partnership — through  an  agreement  on  the  part  of 
two  or  more  men  who  are  acquainted  with  each  other,  to  join 
forces  in  a  business  enterprise.  In  a  partnership,  these  men 
sign  a  formal  partnership  agreement  and  pool  part  or  all  of 
their  capital  and  other  resources;  in  a  corporation  they  mu- 
tually agree  upon  the  amount  of  capital  required,  the  amount 
of  capital  stock  to  be  authorized,  and  the  issuance  of  the  stock 
for  cash,  property,  and  services.  No  matter  which  financial 
form  is  adopted,  the  essential  fact  common  to  both  is  that  the 
money  and  the  business  ability  required  for  the  enterprise  are 
both  supplied  by  the  same  group  of  men. 

As  the  corporation  expands — assuming  that  it  is  a  success 
— and  fresh  capital  is  needed,  it  may  come  in  whole  or  in  part 
from  the  same  group  of  men.  In  case  their  capital  has  been 
exhausted  or  is  otherwise  tied  up,  the  next  move,  frequently, 
is  to  find  some  other  man  who  has  capital  to  invest  and  at  the 
same  time  will  be  a  valuable  addition  to  the  executive  staff 
of  the  business.  Some  concerns  keep  on  growing  in  this  way 
for  a  long  time.  Other  concerns — ^by  far  the  vast  majority — 
soon  attain  their  normal  volume  of  business  and  thereafter 
need  little  if  any  fresh  capital.  In  both  these  cases,  the  source 
of  capital  plainly  is  the  man  or  group  of  men  who  are  them- 
selves active  in  the  management  of  the  business. 

201 


202  SECURING   CAPITAL 

A  second  source  of  capital,  which  usually  operates  in  con- 
nection with  the  source  just  named,  consists  of  savings  out  of 
the  profits  of  the  business.  Practically  every  concern  saves 
and  adds  to  its  permanent  capital  a  portion  of  its  profits.  In 
corporations  which  are  owned  by  the  people  active  in  the  busi- 
ness, the  tendency  is  strong-  toward  putting  a  large  proportion 
of  the  profits  back  into  the  business.  The  active  men  realize 
the  needs  and  the  possibilities  in  the  business  better  than  out- 
side stockholders  could  possibly  do.  Sometimes  they  are 
willing  to  put  back  practically  all  the  profits  and  to  keep  up 
this  policy  over  a  period  of  years.  The  enormous  capital  of 
the  Carnegie  Steel  Company  was,  for  example,  almost  wholly 
built  up  by  this  method.  Much  the  same  thing  is  true  of  the 
Winchester  Arms  Repeating  Company  and  of  many  other 
closely  held  and  highly  successful  concerns.  A  conspicuous 
recent  example  of  the  great  results  which  may  be  achieved 
by  the  patient  saving  and  reinvesting  of  good  profits  over  a 
series  of  years,  is  the  Bethlehem  Steel  Corporation. 

Most  companies  that  are  successful  on  a  large  scale  reach 
the  point,  in  the  course  of  a  few  years,  where  more  capital  is 
needed  than  can  possibly  be  supplied  by  the  people  who  are 
directly  engaged  in  handling  the  business.  Some  corporations, 
as  we  shall  see,  reach  this  stage  at  the  very  beginning;  that  is 
to  say,  they  start  full  blown  as  publicly  owned  enterprises. 
They  are,  however,  exceptional.  Whenever  it  is  necessary  to 
go  outside  the  group  of  men  who  are  directly  connected  or 
directly  familiar  with  the  enterprise,  the  capital  may  be  said 
to  be  raised  from  the  public  at  large.  For  our  purpose  we 
may  divide  this  public — as  is  customarily  done  in  nearly  all 
writing  or  thinking  on  financial  subjects — into  two  fairly 
distinct  groups — those  who  invest  and  those  who  speculate. 
The  investing  public  consists  of  the  people  who  are  more  con- 
cerned over  getting  back  their  principal  than  they  are  over 
making  profits.     The  speculative  public  consists  of  those  who 


J 


SOURCES   OF   CAPITAL   FUNDS  203 

are  chiefly  concerned  in  making  profits,  and  for  this  purpose 
are  willing  to  accept  more  or  less  risk  with  the  principal.  It 
has  previously  been  noted  that  distinct  types  of  security  issues 
are  designed  to  appeal  to  these  two  groups.  There  is,  of 
course,  no  sharp  dividing  line. 

So  far  as  the  issuance  of  securities  is  concerned,  there  is 
little  to  be  said  at  this  point  in  connection  with  the  first  and 
second  sources  of  funds  named  above — persons  close  to  the 
business  and  the  profits  of  the  business.  Some  attention  must 
be  given,  however,  to  the  forms  of  securities  that  should  be 
selected  if  an  appeal  is  to  be  made  to  the  third  source,  the 
investing  public,  or  to  the  fourth  source,  the  speculative  public. 

The  Investing  Public 

The  word  "public"  suggests  a  large  crowd  of  individuals, 
and  the  term  ''investing  public''  may  easily  call  up  a  vivid  pic- 
ture of  thousands  of  staid  and  prosperous  persons  who  per- 
sonally tuck  away  their  own  bonds  in  their  strong  boxes  and 
whose  chief  labor  consists  in  cutting  off  the  coupons.  This 
picture  is  to  a  certain  degree  true  of  the  purchasers  of  those 
investments  which  have  a  slightly  speculative  tinge,  such  as 
bonds  that  sell  on  a  basis  of  5^%  or  more.  John  Moody, 
however,  is  authority  for  the  statement  that  the  ''gilt-edge" 
investment  securities  are  taken  chiefly,  not  by  individuals,  but 
by  institutions.  These  securities  sell  on  the  basis  of,  say,  3% 
to  5J^%,  and  the  individual  investor  is  much  more  apt  to  be 
a  contributor  in  some  way  to  the  support  of  these  large  invest- 
ing institutions,  rather  than  a  direct  purchaser  of  this  type  of 
securities. 

Banks  and  Institutions 

First  among  the  institutional  investors,  we  find  banks. 
Savings  banks  are  enormous  purchasers  of  the  highest  grade 
bonds.     Under  the  laws  of  most  states  their  purchases  are 


204 


SECURING   CAPITAL 


clearly  restricted  to  bonds  of  a  certain  approved  class  which 
are  frequently  referred  to  in  Wall  Street  as  "savings  bank 
bonds."  Commercial  banks,  also,  from  time  to  time  take 
large  quantities  of  investment  securities,  chiefly  short-term 
obligations.  Insurance  companies  spend  a  va^t  amount  an- 
nually in  the  purchase  of  investment  securities.  All  institu- 
tions the  funds  of  which  are  held  in  trust,  such  as  universities, 
philanthropic  institutions,  and  the  like,  must  confine  themselves 
strictly  to  investment  securities.  Estates  of  deceased  persons, 
administered  in  trust,  are  large  purchasers. 

Institutions,  then,  constitute  the  public  to  which  the  highest 
grade  investment  securities  must  be  sold.  Individuals  handling 
their  own  funds  are  free  to  exercise  their  discretion  and  take 
whatever  slight  degree  of  risk  there  may  be  in  the  purchase  of 
securities  that  do  not  comply  with  the  strict  terms  of  the  laws 
covering  institutional  investment. 

It  will  be  readily  seen  that  there  are  noteworthy  advan- 
tages to  the  corporation  which  can  adapt  any  important  part 
of  its  securities  to  the  requirements  of  institutional  invest- 
ment. First  of  all,  such  securities  are  in  high  demand  and  sell 
at  excellent  prices.  Second,  they  are  likely  to  "stay  put"  after 
they  are  sold.  The  institution  ordinarily  does  not  die  or  become 
hard  up  or  easily  panic-stricken ;  consequently,  securities  which 
it  has  once  purchased  are  likely  to  remain  with  it  until  they 
mature.  Throughout  the  crisis  in  the  affairs  of  the  New 
Haven  Railroad  Company  in  1913-1914,  the  debentures  of  the 
company,  which  were  closely  held  by  insurance  companies  and 
savings  banks,  did  not  to  any  great  extent  come  on  the  market 

Investment  Associations 

In  other  countries  even  those  individual  investors  who  in 
this  country  would  buy  securities  direct  are  apt  to  efface  them- 
selves as  individuals  and  join  investment  trusts  or  investment 
associations.    These  associations  are  common  in  Great  Britain, 


SOURCES    OF   CAPITAL    FUNDS 


205 


France,  and  Holland,  and  are  not  uncommon  in  other  coun- 
tries. The  investment  associations  frequently  sell  their  own 
bonds  as  well  as  their  own  shares.  They  take  the  money  thus 
obtained  and  invest  it  in  securities  of  other  corporations. 
What  is  the  advantage,  it  may  be  asked,  of  this  indirect  method 
of  investing  ? 

The  great  advantage  is  that  the  uninformed  judgment  of 
the  individual  who  purchases  only  a  few  stray  securities  from 
time  to  time,  is  replaced  by  the  trained  and  experienced  judg- 
ment of  men  well  acquainted  with  investment  securities  and 
the  investment  market.  This  at  least  is  the  theory  of  the  situ- 
ation. There  is  another  advantage,  also,  In  the  fact  that.  In- 
stead of  having  available  for  investment  only  the  small  savings 
of  individuals,  the  investment  association  deals  In  large  sums 
and  is  therefore  in  a  position  to  buy  advantageously.  Further- 
more, on  account  of  its  large  purchases  it  can  distribute  its 
risk  over  a  wide  field.  Its  securities,  for  instance,  would  not 
all  be  bought  in  one  country  but  In  several  countries;  they 
would  not  all  be  in  one  or  two  lines  of  business,  but  In  several 
lines,  and  so  on.  This  principle  of  the  distribution  of  risk  is 
the  most  practical  form  of  Insuring  the  safety  of  the  Invest- 
ment that  has  yet  been  brought  forth.  The  investment  associa- 
tions, as  a  rule,  are  managed  with  skill  and  ability  and  In  the 
long  run  make  money;  though  there  are,  of  course,  some  un- 
fortunate exceptions. 

Speculative  Public 

The  purchasers  of  speculative  or  even  semi-Investment 
securities  are,  with  negligible  exceptions,  individuals.  The 
term  "semi-investment"  in  this  connection  is  applied  to  such 
securities  as  high-grade  preferred  stocks  and  junior  bonds, 
which  are  customarily  regarded  as  reasonably  safe  but  which 
are  subject  to  a  greater  degree  of  fluctuation  and  uncertainty 
than  the  strictly  high-grade  investments.     There  is  a  fairly 


k 


2o6  SECURING   CAPITAL 

clear  three-fold  division  of  the  immense  number  of  purchasers 
and  possible  purchasers  of  speculative  and  semi-investment 
securities : 

1.  The  buyers  who  have  in  view  primarily  the  safety  of 
their  principal,  in  which  they  do  not  anticipate  any  great  ap- 
preciation in  value,  but  who  desire  a  larger  rate  of  return  than 
can  be  obtained  from  strictly  investment  securities.  These  are 
the  purchasers  of  junior  bonds,  preferred  shares,  and  the  like. 

2.  The  purchasers  who  are  looking  primarily  for  an  in- 
crease in  the  value  of  their  principal,  though  they  do  not 
object,  naturally,  to  a  high  percentage  of  yield.  These  are 
the  purchasers  of  common  shares,  especially  those  which  are 
not  so  thoroughly  seasoned  as  to  approach  the  semi- 
investment  grade  of  securities.  The  members  of  this  group 
are  likely  to  be  for  the  most  part  people  who  have  some  especial 
connection  with,  or  interest  in,  the  corporation,  the  shares  of 
which  they  are  purchasing;  often  they  are  minor  officers  or 
employees  of  the  corporation. 

3.  The  speculators  on  margin,  who  operate  on  the  Wall 
Street  and  other  stock  exchanges.  A  large  number  of  them 
are  merely  gambling;  others  have  some  special  information 
as  to  a  given  corporation  the  shares  of  which  are  listed  on 
the  stock  exchange,  and  are  trying  to  make  capital  out  of  their 
information.  Still  others  are  observers  of  general  market 
conditions,  and  buy  and  sell  standard  issues  with  little  regard 
to  their  intrinsic  value,  but  with  a  great  deal  of  regard  for 
the  buying  and  selling  movements  on  the  exchange  which  they 
see  in  progress. 

Some  of  the  details  in  this  rough  outline  sketch  will  be 
filled  in  later  when  studying  methods  of  selling  security  Issues. 

Wide  Distribution  of  Shares 

A  remarkable  feature  of  the  last  ten  or  fifteen  years  in  the 
United  States  has  been  the  widening  distribution  of  the  shares 


SOURCES    OF    CAPITAL    FUNDS 


207 


of  large  corporations,  indicating  that  a  greater  and  greater 
number  of  people  who  possess  or  can  save  capital  are  putting 
their  money  into  corporate  securities.  Taken  in  the  aggregate, 
the  size  of  the  speculative  public  in  the  United  States  is  enor- 
mous. The  Wall  Street  Journal  calculates  that  327  large  cor- 
porations in  191 3  had  a  total  of  1,251,468  shareholders  listed 
on  their  books.  Even  after  making  a  liberal  allowance  for 
duplications,  the  number  is  strikingly  large.  Many  of  the 
stockholders  are  small.  The  327  corporations  analyzed  have 
a  combined  share  capital  of  $12,871,327,450.  The  average 
holding  of  railroad  shares  is  $13,320;  of  industrial  shares, 
$8,500.  For  industrial  shares  the  average  holdings  in  recent 
years  are  as  follows : 

1901,  $22,000  191 1,  $10,000 

1906,     14,000  1913,       8,500 

The  United  States  Steel  Corporation  has  over  124,000 
shareholders  of  record,  among  whom  are  included  many  for- 
eign investment  associations  and  other  holders  who  are  prac- 
tically trustees  for  a  considerable  number  of  other  people, 
so  that  the  total  number  of  persons  financially  interested  in 
the  United  States  Steel  shares  is  thought  to  be  about  150,000 
to  160,000;  40,000  of  the  shareholders  are  its  own  employees 
and  they  constitute  about  one-sixth  of  the  total  number  of 
employees  of  the  corporation.  In  1901  the  average  holding 
of  United  States  Steel  shares  was  $32,000;  in  1906,  $15,000; 
in  19 1 3,  $7,000.  The  average  holdings  of  other  important 
companies  compare  as  follows : 

1901  1913 

American  Telephone  &  Telegraph  Co.     $14,105        $6,400 

American  Radiator  Company    30,800  8,700 

American  Tobacco  Company 33,700         14,185 

Burroughs  Adding  Machine  Company       24,000         24,000 
Borden's  Condensed  Milk  Company       367,646         10,630 

General  Electric  Company 6,900  7,400 

United  Fruit  Company 7»500  4,842 


2o8  SECURING   CAPITAL 

It  is  clear  from  all  these  facts,  that  the  most  successful 
and  most  popular  corporations  are  carefully  cultivating  the 
good-will  of  the  owners  of  small  amounts  of  capital,  including 
their  own  employees,  and  that  a  notable  transfer  of  ownership 
into  the  hands  of  a  larger  number  of  people  is  in  process. 
This  does  not,  for  the  present,  necessarily  mean  a  transfer  of 
control,  which  is  usually  safely  in  the  hands  of  a  few  large 
holders  of  shares.  Yet  it  involves  some  tendency  at  least 
toward  corporate  democracy,  both  in  the  ownership  and  in 
the  control  of  large  corporations. 

Selling  Shares  of  Smaller  Corporations 

From  this  same  source,  the  speculative  public,  must  come 
the  capital  of  small  enterprises.  After  an  enterprise  has  passed 
the  stage  in  which  the  capital  is  furnished  by  those  directly 
engaged  in  the  enterprise,  if  the  business  itself  is  worthy  and 
sufficiently  profitable,  there  is  no  good  reason  why  it  should 
ever  fail  from  lack  of  sufficient  capital.  The  difficulty  in  most 
instances  where  needed  capital  is  not  obtained,  consists  in 
the  very  common  delusion  that  the  capital  is  to  be  sought  far 
away  from  home.  When  one  of  the  enormous,  nationally 
known  corporations,  with  years  or  perhaps  generations  of 
success  behind  it,  desires  to  obtain  some  millions  of  dollars  of 
fresh  capital,  its  officers  enter  into  a  contract  with  some  bank- 
ing firm  which  undertakes  to  furnish  the  capital  and  which  in 
turn  disposes  of  the  securities  of  the  corporation  among  its 
own  clientele.  This  is  the  big-scale  method  of  raising  fresh 
capital  from  the  speculative  public.  The  actual  work  of  sell- 
ing the  corporate  stock  is  not  performed  by  the  corporation's 
officers.  All  that  they  need  to  do  is  to  make  the  right  kind  of 
contract.  Often  the  manager  of  a  small  local  corporation 
forms  the  idea  that  he  should  and  can  raise  his  capital  in  the 
same  impersonal  way.  He  altogether  forgets  that  his  neighbor 
Jones  has  just  sold  a  farm  and  has  $10,000  lying  idle  in  the 


SOURCES    OF    CAPITAL   FUNDS  200 

bank ;  that  his  customer  Smith  is  a  good  personal  friend  of  his 
and  can  raise  any  reasonable  amount  of  money;  that  his  em- 
ployee Brown  is  building  up  a  good-sized  savings  account  and 
would  save  more  and  work  better  if  he  were  stimulated  by  the 
pride  of  owning  an  interest  in  his  employer's  business.  Instead 
of  interviewing  Jones,  Smith,  and  Brown,  with  money  in  their 
pockets  which  they  would  willingly  exchange  for  shares  in  his 
enterprise,  the  corporate  manager  of  the  type  we  have  in  mind 
is  apt  to  think  that  some  broker  in  a  distant  city  could  easily 
raise  the  $10,000  or  $50,000  that  is  needed  if  he  could  only  be 
persuaded  to  undertake  the  job. 

The  best  place  to  start  in  looking  for  purchasers  of  specu- 
lative or  semi-investment  securities  of  a  small  corporation  is 
among  business  acquaintances  of  the  men  who  are  already 
interested  in  the  corporation.  After  a  few  of  these  acquaint- 
ances  have  themselves  become  shareholders,  they  will  co- 
operate in  reaching  other  people,  and  so  the  list  of  prospective 
purchasers  of  the  securities  will  expand  in  an  ever-widening 
circle  until  the  whole  amount  of  the  capital  required  has  been 
raised.  The  best  person  to  whom  to  turn  for  advice,  ordinarily, 
is  the  most  progressive  banker  in  the  community  or — if  it  is 
a  large  city — the  bankers  best  acquainted  with  the  trade  in 
which  the  corporation  is  engaged.  It  is  the  banker's  business 
to  know  the  financial  standing  of  his  customers.  If  he  is 
willing  to  say  a  good  word  for  the  enterprise,  it  will  go  a  long 
way.  At  any  rate  his  advice  will  be  worth  having.  It  may  be 
safely  said  that  any  corporation  which  has  a  really  attractive 
ofTer  to  make  to  the  stock-buying  public  need  not  apply  in 
vain. 

Adaptation  of  Securities  to  Market 

In  previous  chapters  the  principal  forms  of  security  issues 
■ — common  and  ordinary  shares,  preferred  shares,  income 
bonds,  debentures,  collateral  trust  bonds,  mortgage  bonds,  and 


210  SECURING   CAPITAL 

the  like — have  been  described.  The  point  has  been  emphasized 
that,  while  there  are  favored  and  popular  forms  of  security 
issues,  there  are  no  invariable  forms.  Some  kind  of  a 
security  issue  can  be  found  that  will  suit  both  the  taste  and 
the  pocketbook  of  anyone  who  has  capital  at  his  disposal. 
The  financial  manager  of  a  business  enterprise  will  make  it 
his  business  to  make  such  adaptations  of  the  securities  he  has  to 
offer  as  will  best  fit  them  for  the  market  he  is  trying  to  reach. 
If  his  prospective  purchasers  are  people  of  small  income,  he 
may  find  it  best  to  issue  shares  of  a  par  value  of  $5  or 
$10,  instead  of  the  conventional  $100.  At  the  other  end  of 
the  scale,  if  he  is  getting  out  a  note  issue  exclusively  for 
sale  to  some  of  the  big  institutions,  he  will  perhaps  give  his 
notes  a  par  value  of  $10,000  or  even  $100,000.  He  will  give 
reasonable  attention,  also,  to  passing  fashions  or  popular  in- 
terests. In  one  year  convertible  bonds  are  much  talked  about 
and  easily  sold.  In  another  year  the  popular  interest  is 
centered  largely  on  industrial  preferred  shares.  In  another 
year  there  is  an  unreasoning  aversion,  let  us  say,  to  collateral 
trust  bonds.  Any  successful  dealer  in  securities  will  advise 
that  these  fashions  and  whims  on  the  part  of  the  investing 
public  be  not  ignored. 

In  choosing  forms  of  securities,  unfamiliar  financial 
devices  are  not  usually  favored  unless  they  are  brought  for- 
ward by  some  individual  or  corporation  with  great  prestige. 
The  financial  conditions  at  the  time  when  the  security  is 
brought  out  must  also  be  carefully  considered.  It  has  previ- 
ously been  suggested  that  short-term  notes  have  been  issued 
by  railroad  and  other  corporations  in  the  United  States  in 
great  quantities  during  recent  years,  partly  because  there  is 
a  public  preference  for  such  notes  and  partly  also  because 
it  has  been  hoped  from  year  to  year  that  the  world-wide 
financial  depression  would  give  way  to  a  better  market  for 
long-term  issues.     The  wisdom  or  unwisdom  of  this  course 


SOURCES   OF   CAPITAL   FUNDS  211 

need  not  be  here  considered.  The  point  to  be  made  here  is 
that  the  large  corporations  have  been  consciously  endeavoring 
to  adjust  their  security  issues  to  current  conditions  in  the 
security  market. 

A  striking  example  of  very  poor  judgment  in  failing  to 
make  this  adjustment  is  to  be  found  in  the  history  of  the  ill- 
fated  Cordage  combination.  In  April,  1893,  the  National 
Cordage  Company  had  an  inventory  consisting  of  between 
$5,000,000  and  $6,000,000  of  binder  twine,  against  which 
it  had  borrowed  more  than  $5,000,000  from  New  York  and 
Boston  banks.  While  it  was  in  this  critical  condition  the 
crisis  of  1893  became  more  and  more  threatening  and  some 
of  the  bankers  notified  the  company  that  their  loans  must  be 
at  least  in  part  repaid  on  maturity.  On  Friday,  April,  28, 
1893,  the  shares  of  the  National  Cordage  Company  were 
selling  at  excellent  prices,  the  preferred  at  103^  and  the  com- 
mon at  61,  and  the  credit  of  the  company  was  high.  The 
following  morning  at  a  special  meeting  of  the  board,  it  was 
decided  to  take  care  of  the  demands  of  the  banks  by  an 
immediate  offer  to  the  common  shareholders  of  $2,500,000 
of  new  preferred  shares  at  par.  This  was  equivalent  to 
giving  the  common  shareholders  a  privileged  subscription  of 
some  slight  value.  Under  ordinary  conditions  there  would 
have  been  little  doubt  as  to  the  success  of  this  move.  But 
the  conditions  were  not  ordinary.  The  action  of  the  board 
was  interpreted  in  the  light  of  the  general  feeling  of  sus- 
picion and  uncertainty  as  to  the  soundness  of  all  corporations. 
On  the  following  Monday  a  bear  party  attacked  the  National 
Cordage  Company's  shares  and  the  market  price  of  the  com- 
mon fell  below  50;  two  days  later  it  had  gone  down  to  36. 
Under  these  conditions  it  was,  of  course,  out  of  the  question 
to  make  a  success  out  of  the  preferred  stock  issue.  The 
banks  became  alarmed  and  demanded  immediate  and  full  re- 
payment and  the  company  suddenly  collapsed.    It  was  one  of 


212  SECURING   CAPITAL 

the  most  surprising  and  spectacular  insolvencies  that  is  to 
be  found  in  the  financial  history  of  the  country.* 

Every  possible  measure  should  be  taken  to  meet  the  con- 
venience of  prospective  purchasers  in  putting  out  bond  issues 
of  large  corporations  v;^hich  enjoy  an  international  market; 
for  example,  it  is  customary  and  proper  to  make  interest 
payable  at  the  principal  cities  of  the  various  countries  in 
which  the  bonds  are  likely  to  be  sold.  There  are  a  number 
of  issues  of  this  country  the  interest  on  which  may  be  col- 
lected in  Paris,  London,  Berlin,  or  New  York. 

Earnings  and  Security  Issues 

Up  to  the  present  point  in  this  chapter  we  have  considered 
only  the  relations  between  security  issues  and  the  needs  or 
notions  of  the  prospective  purchaser  of  these  issues.  It  is, 
of  course,  clear  that  there  must  be  a  correspondence  also  be- 
tween the  security  issues  and  the  needs  of  the  corporation. 
The  mere  fact  that  a  security  of  a  given  type  is  thought  to 
be  easily  salable  is  not  the  final  reason  for  issuing  just  that 
security.  The  corporation's  interests  may  best  be  served  by 
some  other  type  of  security,  and  it  may  be  necessary — in  fact, 
generally  is  necessary — to  make  a  compromise. 

From  the  corporation's  standpoint,  the  outstanding  securi- 
ties should  be  in  correct  relation  both  to  the  assets  of  the 
corporation  and  to  its  earnings.  If  this  correct  relation — or 
an  approximation  to  it — is  not  secured,  then  one  of  two  un- 
desirable results  must  follow:  either  the  capital  required  is 
secured  upon  terms  that  are  more  or  less  onerous  and  wasteful, 
or,  on  the  other  hand,  the  corporation  is  burdened  with  claim* 
which  it  may  not  be  able  to  meet  and  which,  therefore,  en- 


*Undoubtedly  the  National  Cordage  Company  was  in  unsound  financial  conditio! 
but  it  need  not  necessarily  have  gone  down  just  at  this  time  if  it  had  not  been  for  thi 
imprudence  of  the  directorate  in  failing  to  give  due  consideration  to  the  general  marke 
conditions.  It  seems  probable  that  their  action  was  hasty  and  taken  without  prope 
financial  advice.  (See  remarks  in  Dewing's  "Corporate  Promotions  and  Reorganiza 
tions.") 


SOURCES   OF   CAPITAL   FUNDS  213 

danger  its  continued  existence.  The  first-named  fault  is 
probably  both  less  frequent  and  less  to  be  "condemned  than  the 
second  fault. 

Some  conspicuous  examples  of  wastefulness  In  raising  cor- 
porate capital  may  readily  be  picked  out.  The  Singer  Sewing 
Machine  Company,  although  it  possesses  tangible  assets  of 
enormous  value,  has  no  bonds  or  preferred  shares  outstanding, 
but  only  its  $60,000,000  of  common  shares.  The  same  thing 
is  true  of  the  Pullman  Company  which  ha^  only  its  one  issue 
of  $20,000,000  common  outstanding;  the  Mergenthaler  Lino- 
type Company  with  its  one  issue  of  $12,786,700  common 
stock;  and  the  Arlington  Mills  with  $6,000,000  in  common 
stock.  All  these  corporations  could  sell  with  reasonable  safety 
— and  during  many  years  in  the  past  could  have  sold — bond 
or  preferred  share  issues  by  means  of  which  capital  could  be 
raised  at  a  rate  considerably  less  than  through  the  issue  of 
common  shares.  All  these  corporations,  it  is  true,  are  ex- 
ceptionally prosperous;  their  shareholders  are  well  satisfied 
and  perhaps  would  prefer  the  complete  safety  of  their  present 
position  to  the  qualified  safety  which  they  would  enjoy  if 
prior  claims  ranked  ahead  of  them.  Nevertheless,  it  is  true 
that  earnings  on  the  common  shares  would  no  doubt  be  con- 
siderably higher  if  the  required  capital  had  been  obtained  in 
part  through  bond  and  preferred  share  issues.  The  truth  of 
the  case  is  that  the  assets  of  all  these  corporations  have  been 
accumulated  chiefly  out  of  surplus  earnings  and  the  profits 
have  been  so  large  that  there  has  been  no  occasion  to  depend 
upon  security  issues  to  any  great  extent  for  fresh  capital.  The 
objection  that  is  here  raised  to  their  present  arrangement  of 
security  issues  is,  therefore,  it  may  be  freely  granted,  of  an 
academic  nature.  If  these  and  other  prosperous  corporations 
which  have  relied  wholly  on  common  stock  issues  have  erred 
at  all,  it  has  clearly  been  on  the  side  of  conservatism  and 
safety. 


214 


SECURING   CAPITAL 


Effect  of  Limitation  to  Common  Stock 

There  are  other  corporations,  however,  the  business  of 
which  is  not  profitable  to  so  remarkable  an  extent,  and  which 
have  actually  caused  unnecessary  sacrifices  to  their  stock- 
holders by  reason  of  a  blind  adherence  to  the  policy  of  putting 
out  only  common  stock.  If  a  public  utility  company,  for  ex- 
ample, were  to  attempt  to  finance  itself  solely  by  the  sale  of 
common  stock,  the  chances  are  that  there  would  be  very  little 
money  for  anyone  interested.  The  profits  on  such  enterprises 
are  comparatively  limited,  and  the  financing  must  be  watched 
with  the  closest  attention  in  order  to  preserve  reasonably  good 
earnings  for  the  benefit  of  the  common  shares.  This  can  be 
made  clearer  by  a  hypothetical  case  than  by  any  example 
which  is  at  hand,  for  practically  all  public  utility  companies 
do  raise  the  greater  portion  of  their  capital  through  issuing 
obligations  rather  than  through  issuing  shares.  Let  us  sup- 
pose that  a  public  utility  corporation  requires  $10,000,000 
capital,  and  that  its  net  earnings  amount  to  $600,000,  or  6% 
on  the  invested  capital.  Clearly  this  would  not  in  itself  be 
an  attractive  return  to  prospective  purchasers  of  the  common 
stock.  Let  us  further  assume,  however,  that  $6,000,000  of  the 
required  capital  is  secured  by  bond  issues  at  an  average  cost 
to  the  corporation  of  5%  ;  that  $2,000,000  is  obtained  through 
preferred  stock  or  junior  bond  issues  at  an  average  cost  to  the 
corporation  of  6%  ;  and  that  $2,000,000  consists  of  common 
stock.  In  that  case,  the  annual  profits  would  be  distributed 
as  follows: 

Bonds,  $6,000,000  @  s% $300,000 

Junior  bonds,       2,000,000  @  6% 120,000 

Common  stock,    2,000,000  with  earnings  of  9% . .   180,000 

Total  earnings $600,000 

As  a  matter  of  fact,  it  is  customary  to  provide  all  the  cost 
of  the  tangible  property  of  public  service  enterprises  by  issuH 


SOURCES   OF   CAPITAL   FUNDS  215 

ing  bonds  up  to  about  75%  of  the  cost,  and  preferred  stock 
up  to  about  25%.  The  common  stock  in  this  case  represents 
intangible  assets  and  is  secured  by  the  promoters  of  the  enter- 
prise as  their  profits.  If  this  rule  were  followed  in  the  case 
just  cited,  the  results  would  be  as  follows: 

$7,500,000  bonds  @  5% $375,000 

$2,500,000  bonds  @  6% 150,000 

Available  as  earnings  on  common  stock 75,ooo 


Total $600,000 

Some  interesting  comparisons  may  be  made  among  the 
railroad  corporations  of  the  United  States  in  respect  to  the 
percentage  of  capital  represented  by  means  of  bonded  obliga- 
tions as  compared  with  the  capital  raised  through  stock  issues. 
Following  is  a  list  of  some  of  the  important  railroads  showing 
their  capitalization  in  stock  and  in  bonds  per  mile,  and  the 
percentage  of  each  form  of  security.* 

Pel 
Stock 

Wheeling  &  Lake  Erie $80,567 

Erie    78,100 

Norfolk  &  Western 64,224 

New  York  Central 60,075 

Baltimore  &  Ohio 47,4i3 

Toledo,  St.  Louis  &  Western 44,346 

Union  Pacific 42,364 

Lehigh  Valley 42,089 

Northern    Pacific 39,209 

Chicago  &  Alton 38,679 

Wabash 36,739 

Denver  &  Rio  Grande 33,984 

Great    Northern 29,687 

Atchison   28,418 

Chesapeake  &  Ohio 26,768 

Southern  Pacific 26,162 

C,  C,  C  &  St.  Louis 26,094 

Southern  Railway 25,574 

Illinois    Central 25,013 


Mile 

Per  Cent 

per  Mile 

Bonds 

Stock 

Bonds 

^77,677 

51 

49 

110,847 

41 

59 

54,835 

54 

46 

104,222 

37 

63 

89,892 

35 

65 

65,177 

41 

59 

43,971 

49 

51 

66,556 

39 

61 

30,789 

56 

44 

83,136 

32 

68 

49,381 

43 

57 

51,801 

40 

60 

18,440 

62 

38 

28,712 

50 

50 

74,963 

26 

74 

60,669 

30 

70 

43,904 

37 

63 

40,396 

39 

61 

41,363 

38 

62 

*Copied  from  the  New  York  Annalistj  June  21,  191S. 


Per  Cent 

per  Mile 

stock 

Bonds 

41 

59 

42 

58 

36 

64 

26 

74 

35 

65 

39 

61 

41 

59 

31 

69 

28 

72 

32 

68 

26 

74 

34 

66 

21 

79 

20 

80 

IS 

85 

10 

90 

216  SECURING   CAPITAL 

Per  Mile 

Stock  Bonds 

St.  Paul 24,042  34,418 

St.  Louis  South 22,647  30,834 

Seaboard  Air  Line 20,271  36,244 

Chicago  &  Eastern  Illinois 20,135  58,072 

Missouri,  Kansas  &  Texas 19,955  36,808 

Boston  &  Maine 18,941  30,000 

Northwestern 18,896  27,141 

Atlantic  Coast  Line 14,800  33,345 

Louisville  &  Nashville 14,586  38,376 

Minneapolis  &  St.  Louis 12,933  27,070 

Pere    Marquette 12,263  24,406 

Burlington 12,127  23,504 

Missouri   Pacific 11,428  41,875 

C  R.  L  &  Pacific 10,126  36,604 

Frisco  9,505  55,734 

Cincinnati,  Hamilton  &  Dayton ... .  8,127  70,819 

The  above  table  contains  some  striking  illustrations  of  the 
second  and  more  serious  of  the  two  faults  above  named.  Note 
especially  the  high  percentages  of  bonds  in  the  case  of  roads 
w^hich  are  at  this  wanting  in  the  hands  of  receivers,  including 
the  Cincinnati,  Hamilton  and  Dayton ;  the  Chicago  and  East-  ^ 
ern  Illinois ;  the  Pere  Marquette ;  Frisco ;  Chicago,  Rock  Island 
and  Pacific ;  and  Missouri  Pacific.  On  the  other  hand,  the 
sound  roads,  such  as  the  Pennsylvania  and  the  Great  Northern, 
are,  if  anything,  overconservative  in  their  issue  of  bonds. 
Union  Pacific,  Atchison,  Norfolk  and  Western,  Reading,  etc., 
show  a  proportion  of  approximately  50%  bonds  and  50% 
stock,  which  may  fairly  be  regarded  as  conservative  and  about 
correct.  Of  course,  the  above  percentages  are  suggestive 
only  and  might  lead,  if  taken  wholly  at  their  face  value,  to 
strikingly  wrong  conclusions.  For  example,  the  Wheeling 
and  Lake  Erie,  which  is  notoriously  unsound  financially, 
shows  a  proportion  of  less  than  50%  bonds  out  of  its  total 
capitalization;  but  this  is  to  be  accounted  for,  not  by  con- 
servatism in  issuing  bonds,  but  by  reckless  overissues  of  stock. 


J 


SOURCES    OF    CAPITAL  FUNDS  217 

Adequate  Income  for  Common  Stock  Dividends 

It  would  be  useless  to  give  Illustrations  at  this  point  of 
corporations  which  have  transgressed  the  limits  of  prudence 
in  selling  their  own  obligations  to  the  public,  for  we  shall  be 
dealing  with  such  cases  in  the  later  chapters,  where  financial 
embarrassments,  insolvencies,,  and  reorganizations  are  dis- 
cussed. It  is  obvious,  on  the  face  of  it,  that  a  corporation, 
like  an  individual,  may  abuse  its  credit.  The  rule  of  safety 
in  the  issuance  of  funded  obligations  requires  that  the  cor- 
porate income  shall  at  its  minimum  more  than  cover  the 
fixed  charges,  including  both  interest  payments  and  sinking 
fund  payments  if  any.  The  rule  of  prudence,  which  should 
be  regarded  invariably  in  connection  with  the  contingent 
charges  assumed  when  deferred  shares  or  income  bonds  are 
issued,  is  that  the  corporate  income  over  and  above  all  fixed 
charges  must  be  ample,  under  all  conditions  that  can  reason- 
ably be  anticipated,  to  cover  these  contingent  charges.  The 
rule  of  good  faith  in  connection  with  the  issuance  and  sale 
of  common  stock  should  be  that  the  anticipated  income, 
based  upon  the  probabilities,  should  be  ample  to  provide  in 
addition  to  all  fixed  and  contingent  charges  a  reasonable  and 
increasing  return  on  the  common  shares.  We  may  state 
this  relation  in  tabular  form  as  follows: 

1.  Assured  income  should  be  more  than  enough   for 

fixed  charges. 

2.  Additional    income    anticipated    beyond    reasonable 

doubt,  should  be  more  than  enough  to  cover  con- 
tingent charges. 

3.  Additional    probable   income    should   be   more    than 

enough  to  provide  a  satisfactory  yield  on  common 
shares. 

It  is  true,  of  course,  that  unforeseen  occurrences  frequently 
wreck  even  the  soundest  and  most  careful  estimates,  and 


2i8  SECURING   CAPITAL 

that  the  organizers  and  financial  managers  of  corporations 
are  not  always  entitled  to  severe  censure  because  their  plans 
miscarry.  They  are  clearly  entitled  to  censure,  however,  if 
they  do  not  make  their  estimate  of  future  income  with  rea- 
sonable foresight  and  conservatism,  and  if,  after  having  pro- 
cured sound  estimates,  they  fail  to  observe  the  relations 
above  referred  to  between  earnings  and  security  issues. 

Assets  and  Security  Issues 

The  assets  of  every  business  enterprise   fall  into  three 
natural  divisions: 

1.  Fixed  tangible  assets,  which  are  essential  to  the  proper 

conduct  of  the  business. 

2.  Current  assets,  which  consist  of  cash  and  of  such 

property  as  can  readily  be  converted  into  cash. 

3.  Intangible  assets,  which  have  previously  been  defined 

as  the  capitaHzation  of  the  earning  power  which 
cannot  be  attributed  to  the  other  assets. 

There  is  a  relation  between  these  classes  of  assets  and  the 
security  issues  of  a  corporation,  which  may  be  stated  in  the 
following  form: 

The  actual  value  of  fixed  assets  (not  merely  the  book 
value)  should  exceed  by  at  least  25  to  50%  the 
bonded  obligations  outstanding. 

The  actual  value  of  the  fixed  assets,  plus  the  value  of 
net  current  assets  (after  deduction  of  current  lia- 
bilities) should  at  least  equal,  and  generally  con- 
siderably exceed,  the  outstanding  preferred  shares, 
income  bonds,  or  other  contingent  obligations. 

The  actual  value  of  tangible  assets,  plus  that  of  intan- 
gible assets,  should  equal  or  preferably  exceed,  the 
combined  value  of  fixed  obligations,  contingent  obli- 
gations or  shares,  and  common  shares  outstanding. 


SOURCES   OF   CAPITAL   FUNDS 


219 


I 


Quite  a  large  number  of  industrial  corporations  have  fol- 
lowed the  principle  of  issuing  bonds  and  preferred  shares  up 
to  the  net  value  of  their  tangible  assets,  and  issuing  common 
shares  exactly  equal  to  the  value  of  their  intangible  assets. 
Cluett,  Peabody  and  Company,  the  well-known  manufacturers 
of  collars  and  shirts,  carry  an  account  called  "Good- will, 
Patent  Rights,  Trade-Names,  etc,"  of  $18,000,000,  against 
which  the  corporation  has  outstanding  $18,000,000  of  com- 
mon stock.  The  F.  W.  Wool  worth  Company,  has  good- will 
$50,000,000,  and  common  stock  $50,000,000;  the  Kaufman 
Department  Stores,  Inc.,  of  Pittsburg,  carries  "Good- will, 
Trade-Marks,  Contracts,  and  Leases"  at  $7,500,000,  and  has 
outstanding  common  stock  of  $7,500,000.  The  George  A. 
Fuller  Company  at  its  incorporation  in  1901  presented  a 
balance  sheet  showing  net  quick  assets  of  approximately 
$5,000,000  and  "Tools,  Machinery,  and  Good-will"  of 
$10,000,000;  $5,000,000  of  preferred  and  $10,000,000  of 
common  stock  were  issued. 

In  most  other  cases  the  correlation  between  the  different 
forms  of  securities  and  the  three  classes  of  assets  is  not  so 
direct  and  readily  visible.  But  there  is,  or  should  be,  some 
measure  of  relation.  We  shall  find  further  illustrations  both 
of  acceptance  and  of  rejection  of  this  principle  as  we  proceed. 

Special  Provisions  and  Forms  of  Securities  : 

As  has  been  previously  stated,  there  may  be  any  number 
of  forms  of  security  issues.  The  more  important  types  have 
been  described  in  previous  chapters,  but  a  few  examples  may 
be  cited  here  of  instances  in  which  it  was  desirable  to  make 
unusual  changes  in  order  to  adapt  the  security  to  peculiarities 
in  the  assets  or  in  the  market  conditions.  English  practice 
runs  very  strongly  toward  the  issuance  of  perpetual  or 
irredeemable  debentures,  the  idea  being  that  all  the  debtor 
cares  for  is  to  have  his  interest  paid  regularly,  thus  giving 


220  SECURING   CAPITAL 

him  a  security  which  is  readily  marketable.  Even  the  large 
brewing  companies  in  England,  which  can  hardly  be  thought 
to  have  a  business  that  is  beyond  all  human  vicissitudes,  have 
nevertheless  issued  and  sold  a  large  number  of  these  perpetual 
debentures.  In  America  they  are  practically  unknown  and 
would  probably  be  almost  unsalable.  In  the  United  States  a 
peculiar  security  was  brought  out  by  a  large  distilling  com- 
pany some  years  ago,  consisting  of  a  preferred  stock  issue 
which  was,  however, r^to  be  redeemed  by  the  corporation  and 
was  secured  by  a  first  lien  on  all  the  whiskey  stored  in  bond. 
It  was  further  provided  that  the  holder  of  a  share  of  pre- 
ferred stock  could,  if  he  chose,  take  a  barrel  of  whiskey  in 
payment  of  his  claim.  Even  this  ingenious  arrangement, 
it  is  understood,  did  not  bring  about  the  success  of  the  issue. 

There  has  been  very  little  real  planning  in  the  financial 
development  of  most  corporations.  The  easy  and  obvious 
thing  to  do  is  to  meet  each  financial  difficulty  or  problem  as 
it  comes  along,  in  the  hope  that  there  will  be  no  further 
problems.  Frequently  the  result  is  to  create  a  maze  of  con- 
flicting claims,  and  to  impose  obligations  upon  the  corporation 
which  seriously  interfere  with  the  normal  growth  of  its  credit 
and  lead  to  loss  or  even  to  insolvency. 

The  financial  troubles  which  frequently  come  to  concerns 
that  are  fundamentally  sound  and  prosperous  are  wholly 
unnecessary.  They  could  be  avoided  by  a  moderate  amount 
of  foresight  and  careful  planning.  A  typical  instance  is  that 
of  a  knitting  mill  in  an  eastern  state  which  is  capitalized  at 
$900,000,  $600,000  common  and  $300,000  7%  cumulative 
preferred  stock.  The  quick  assets  are  $450,000  in  excess  of 
its  quick  liabilities,  and  the  company  has  a  surplus  of 
$500,000.  This  corporation,  like  most  all  other  textile  con- 
cerns, borrows  heavily  from  the  banks.  It  seldom  has  loans 
of  less  than  $600,000  outstanding,  and  frequently  they  rise 
to  $900,000;  the  loans  are  obtained  at  an  average  rate  of 


SOURCES   OF   CAPITAL   FUNDS  221 

5/4%.  The  question  that  has  been  raised  and  Is  now  under 
consideration,  is  whether  It  would  be  desirable  to  put  out 
an  additional  $300,000  of  7%  preferred  stock  at  par,  thus 
cutting  down  the  bank  borrowing. 

To  this  question  there  is  apparently  one  sound  answer. 
When  bank  loans  of  this  concern  reach  their  maximum  of 
$900,000,  these  loans  are  equivalent  to  the  whole  capital  stock, 
and  the  margin  of  quick  assets  Is  too  small  for  safety.  A 
failure  to  dispose  of  the  products  of  the  mill  on  the  usual 
terms  and  at  the  usual  time  might  suddenly  bring  on  bank- 
ruptcy. The  case  of  the  National  Cordage  Company  already 
cited  Is  In  point.  Because  of  its  extensive  and  growing  busi- 
ness, the  corporation  Is  evidently  driving  toward  a  possible 
financial  position  of  serious  danger.  It  Is  expected  that  the 
directors  will  shortly  take  action  authorizing  the  sale  of  pre- 
ferred stock  and  reducing  the  bank  Indebtedness  by  a  cor- 
responding amount.  The  result  would  be  to  reduce  tTie  earn- 
ings on  the  common  stock  by  approximately  $4,500  per  year, 
but  this  Is  a  small  Item  compared  to  the  gain  In  safety. 

It  may  be  asked  why  the  problem  Is  not  solved  by  placing 
a  mortgage  upon  the  mill  and  thus  borrowing  on  better  terms 
than  through  the  Issue  of  preferred  shares.  The  answer  Is 
that,  in  the  textile  industry  it  Is  a  well-recognized  principle 
that  mill  property  should  not  be  mortgaged.  Cotton  mills 
borrow  from  the  banks  so  heavily  that  a  banker  would  look 
with  much  disfavor  on  any  permanent  loan  that  would  out- 
rank his  claim. 

Incorporating  a  Partnership 

Many  puzzling  problems  arise  in  connection  with  the 
custom  which  has  become  common  in  recent  years,  of  giving 
up  the  partnership  form  In  establishing  enterprises  and  sub- 
stituting the  corporate  form  of  organization.  During  the 
life  of  the  partnership  numerous  personal  agreements  have 


222  SECURING  CAPITAL 

probably  been  entered  into  which  it  is  difficult  either  to 
continue  or  replace  under  the  corporate  form.  Moreover,  one 
essential  feature  of  the  partnership  form  is  that  every  partner, 
irrespective  of  his  financial  interest,  shall  have  an  equal  voice 
in  the  management  of  the  enterprise.  If  there  is  wide 
discrepancy  between  the  financial  interests  of  the  partners,  it 
is  difficult  to  continue  this  arrangement  under  the  corporate 
form.  The  following  is  a  concrete  example  which  will  make 
clear  these  difficulties: 

Three  partners.  A,  B,  and  C,  conduct  a  jobbing  business 
established  60  years  ago  by  A's  father.  A,  having  inherited 
his  father's  estate,  is  the  principal  owner  and  the  head  of  the 
concern ;  B,  who  began  30  years  ago  as  a  clerk,  is  in  charge  of 
the  production  and  a  large  share  of  the  selling ;  C,  who  entered 
as  a  bookkeeper  20  years  ago,  is  in  charge  of  the  financing, 
office  management,  and  credits.  The  capital  of  the  firm  is 
$325,000,  of  which  A  owns  $275,000,  B  $35,000,  and  C 
$15,000;  interest  at  6%  is  paid  each  partner  on  the  amount 
of  his  investment;  each  partner  draws  a  salary  of  $7,200  per 
annum,  and  the  profits  are  divided  as  follows :  A  50%  ;  B 
40%,  and  C  10%.  The  annual  sales  are  about  $750,000,  and 
the  net  profits  $25,000.  An  important  reason  for  turning 
the  partnership  into  a  close  corporation  is  in  order  to  allow 
department  heads  and  some  of  the  salesmen  to  gain  an  interest 
in  the  business. 

It  is  at  once  evident,  in  considering  this  case,  that  its 
difficulty  arises  out  of  the  fact  that  profits  are  divided  without 
any  fixed  relation  either  to  investment  of  capital  or  to  the 
value  of  services.  Six  per  cent  is  hardly  a  sufficient  rate  of 
return  on  the  capital  employed  in  a  business  of  this  character, 
so  that  it  is  no  doubt  intended  to  give  some  special  allowance 
to  A  in  the  division  of  profits,  that  will  constitute  an  increased 
return  on  his  capital.  However,  this  cannot  be  the  controlling 
interest  since  B,  with  a  comparatively  small  investment,  re- 


SOURCES  OF   CAPITAL   FUNDS 


223 


ceives  40%  of  the  profits.  The  problem  is  to  preserve  these 
various  rights  and  claims  under  the  corporate  form. 

It  would  be  possible  to  issue  6%  bonds  of  the  proposed 
corporation  to  A,  B,  and  C  to  represent  their  respective  invest- 
ments, but,  inasmuch  as  this  is  a  jobbing  business,  it  would  be 
preferable  to  issue  preferred  stock  rather  than  bonds.  We  will 
start,  then,  by  providing  for  the  issuance  of  $325,000  of  6% 
cumulative  preferred  stock;  $275,000  to  A,  $35,000  to  B,  and 
$15,000  to  C.  The  best  method  of  determining  the  total 
amount  of  common  stock  to  issue  is  to  capitalize  the  remaining 
$25,000  of  profit  at  some  reasonable  percentage,  say  8%, 
making  the  common  issue  $312,500.  If  we  assume  that  the 
distribution  of  profits  to  the  three  partners  is  meant  to  repre- 
sent their  permanent  contributions  to  the  upbuilding  of  the 
business,  this  $312,500  of  common  stock  should  be  divided 
among  them,  50%  to  A,  40%  to  B,  and  10%  to  C.  Possibly 
this  division  of  profits  in  the  partnership  is  meant  rather  to 
represent  discrepancies  in  the  abilities  of  the  three  men  in 
directing  the  affairs  of  the  business ;  if  that  is  the  case,  these 
discrepancies  should  be  adjusted  by  corresponding  changes  in 
the  salaries  of  the  three  men,  which  in  turn  would  involve  a 
different  distribution  of  the  common  stock. 

Now  comes  the  dif^culty  of  giving  each  one  of  the  partners 
^an  equal  voice  in  the  management  of  the  corporation  such  as 
he  now  has  in  the  management  of  the  partnership.  The  sim- 
Lplest  method  of  accomplishing  that  result,  and  generally  the 
most  satisfactory,  is  to  create  a  voting  trust,  which  should  not 
be  for  more  than  five  years.  There  would  be  a  possibility,  also, 
of  making  a  part  of  the  common  stock  non-voting,  so  as  to 
make  certain  that  each  of  the  partners  will  be  able  to  elect  a 
member  of  the  board  of  directors,  but  this  is  a  somewhat  cum- 
bersome device.  If  it  is  adopted,  it  would  be  well  to  provide 
in  the  by-laws  for  cumulative  voting  so  as  to  make  impossible 
a  combination  of  two  partners  to  freeze  out  the  third. 


224 


SECURING   CAPITAL 


Financial  Plan  for  a  Railroad 

Another  problem,  which  is  of  especial  interest  in  illus- 
trating some  of  the  principles  discussed,  arose  in  connection 
with  the  proposition  to  finance  the  construction  of  a  short  rail- 
road and  the  establishment  of  a  steamship  service  in  one  of 
the  southern  states.  The  whole  project  involved  an  invest- 
ment, including  terminals,  of  about  $4,183,000.  The  probable 
gross  earnings  after  two  years  from  date  of  opening  the  road 
to  operation,  were  calculated  at  $2,018,000;  operating  ex- 
penses were  estimated  at  65%,  say  $1,300,000,  and  taxes  and 
insurance  at  $80,000,  making  the  total  expense,  $1,380,000, 
and  leaving  a  net  revenue  of  $626,125  from  which  to  meet 
fixed  charges  and  provide  a  surplus.  It  is  estimated  also,  that 
there  would  be  a  deficit  close  to  $100,000  during  the  first 
two  years  of  operation.  Equipment  was  expected  to  cost 
$1,650,000.    The  total  capital  required  was  as  follows: 

Cost  of  construction $4,183,000 

Cost  of  equipment   1,650,000 

Loss  in  first  two  years  of  operation 100,000 

Working  capital 500,000 

Total $6,433,000 

A  certain  amount  of  capital  required  for  the  earlier  stages 
of  construction  is  necessarily  tied  up  without  any  income  to 
pay  the  interest  on  it,  until  the  road  is  put  in  operation.  To 
take  care  of  this  expense  it  would  be  well  to  form  a  construc- 
tion company  to  build  the  road  and  furnish  all  other  necessary 
property  and  cash.  The  construction  company  should  be  pre- 
pared to  hand  over  to  the  railroad  company  $600,000,  that 
sum  being  required  to  cover  the  loss  of  the  first  two  years  of 
operation  and  to  provide  working  capital.  The  construction 
company  should  also  pay  interest,  taxes,  insurance,  etc.,  up 
to  the  time  the  property  is  handed  over  to  the  railroad  com- 
pany.   In  exchange  for  the  railroad  and  the  cash,  the  railroad 


SOURCES   OF  CAPITAL   FUNDS  22$ 

company  would  then  turn  over  all  its  securities  to  the  construc- 
tion company,  which  securities  the  construction  company  would 
sell  and  out  of  which  it  would  derive  its  profit.  The  pro- 
moters of  the  railroad  would  naturally  be  the  owners  of  the 
construction  company. 

On  the  basis  of  normal  earnings  of  $626,125,  the  corpora- 
tion might  be  capitalized  as  follows : 

Cash  Fixed  and 

Nominal  Receipts  to  Contingent 
Value  Corporation  Charges 
5l4%  first  mortgage  bonds  on  all 
property,  exclusive  of  equip- 
ment, to  be  disposed  of  at  90 
with  a  bonus  of  two  shares  of 
common   stock  to  each  $1,000 

bond    $4,000,000         $3,600,000         $220,000 

6%  one  to  ten-year  serial  equip- 
ment notes   1,500,000  1,500,000  90,000 

Annual  payment  during  first  ten 
years    of    operation    to    retire 

above   notes    150,000 

7%  cumulative  stock  to  be  dis- 
posed of  at  90,  with  a  bonus 
of  common  to  each  five  shares 
of   preferred    1,500,000  1,350,000  105,000 

$7,000,000        $6,450,000        $565,000 

This  leaves  a  balance  of  $61,125  a  year  available  for  con- 
tingencies out  of  the  income  of  the  first  ten  years. 

The  common  stock  required  for  bonuses  to  purchasers  of 
the  first  mortgage  bonds  and  of  the  preferred  stock,  is 
$1,300,000.  The  promoters  of  the  enterprise  will  want  some 
pay  for  their  services,  and  will  probably  want  to  retain  con- 
trol of  the  company.  They  should,  therefore,  issue  approxi- 
mately $4,000,000  of  common  stock  to  the  construction 
company.  Under  the  above  estimates  $2,700,000  will  be  left 
for  themselves. 

For  the  first  ten  years — ^unless  the  earnings  should  largely 


226  SECURING   CAPITAL 

increase — the  common  stock  could  not  expect  to  receive  any 
dividends.  It  will  be  noticed  that  $150,000  worth  of  serial 
notes  is  to  be  retired  each  year,  and  that  the  interest  on  that 
amount  each  year  should  be  added  to  the  balance  available 
for  contingencies.  At  the  end  of  ten  years,  not  only  will 
there  be  no  interest  to  pay  on  the  notes  but  the  annual  pay- 
ments on  the  principal  will  cease.  Thereafter  $301,125  may 
be  disbursed  as  dividends  on  the  common  stock.  This  means 
about  7J^%  earnings  on  the  common  stock. 

It  will  be  noted  that  in  the  above  arrangement,  first  mort- 
gage bonds  are  issued  to  an  amount  approximately  equal  to 
the  actual  cost  of  the  property  mortgaged.  This  may  seem  to 
be,  and  is  in  fact,  somewhat  reckless  financing;  yet  it  must  be 
assumed  that  the  project  itself  is  worth  something  and  that 
the  rails,  buildings,  and  real  estate,  which  are  the  chief  items 
in  cost,  are  worth  more  after  they  are  laid  down  and  the  rail- 
road is  ready  for  operation,  than  their  actual  cost.  The  pre- 
ferred stock  is  more  than  equivalent  to  the  remaining  balance 
of  all  the  tangible  assets  and  is  partly  offset  by  good-will.  The 
proposed  common  stock  issue  of  $4,000,000  is  offset  wholly  by 
good-will.  The  amount  of  each  class  of  security  that  may 
safely  be  issued  has  been  determined  rather  with  reference  to 
the  earnings  than  with  reference  to  the  assets.  It  is  assumed] 
that  there  is  little  likelihood  of  failure  to  meet  the  fixed  charges 
amounting  to  $460,000. 

Financing  an  Advertising  Agency 

At  the  other  end  of  the  scale  from  a  railroad  company  ij 
an  enterprise,  such  as  an  advertising  agency,  which  renders 
service  that  is  largely  of  a  personal  nature  analogous  to  th« 
service  rendered  by  a  lawyer,  physician,  or  consulting  engineerJ 
It  is  true,  of  course,  that  many  of  the  functions  of  an  adver-j 
tising  agency  are  of  a  more  or  less  clerical  nature;  but  th< 
more  important  functions  are  advisory  and  cannot  be  per] 


SOURCES   OF   CAPITAL   FUNDS  227 

formed  properly  except  by  well-qualified,  high-priced  men. 
For  this  reason  the  growth  of  an  advertising  agency,  if  it  is  a 
healthy,  permanent  growth,  is  necessarily  a  rather  slow  process. 
The  time  and  energy  of  the  principals  are  limited,. and,  if  an 
attempt  is  made  to  spread  their  efforts  over  too  many  under- 
takings, the  result  is  apt  to  be  unsatisfactory  both  to  their 
clients  and  to  themselves. 

It  would  seem,  therefore,  in  considering  the  financial  prob- 
lems of  an  established  agency,  that  a  reasonably  rapid  growth 
ought  to  be  financed  directly  out  of  the  profits  of  the  agency. 
It  is  not  necessary  to  maintain  a  great  working  capital  in  pro- 
portion to  the  volume  of  business  handled,  for  an  advertising 
agency  usually  pays  its  bills  on  the  same  terms  that  its  own 
bills  to  clients  are  paid  by  them.  For  example,  if  an  advertis- 
ing agency  gets  a  discount  of  2%  for  cash  in  10  days,  it  should 
give  the  same  discount  to  its  clients  and  thus  secure  the  cash 
from  them  with  which  to  meet  the  bill. 

In  one  instance,  however,  an  advertising  agency  was  as- 
sisting some  of  its  clients  to  carry  on  large  advertising  cam- 
paigns by  granting  them  extra  time  for  the  payment  of  their 
accounts  while  the  advertising  agency  was  paying  its  own  bills 
on  the  minute.  The  result  was  that  it  suddenly  became  neces- 
sary to  add  $75,000  to  $100,000  to  the  working  capital  of  the 
agency.  The  agency  had  been  in  existence  for  many  years, 
was  highly  regarded,  and  was  making  satisfactory  profits,  so 
that  its  record  favored  the  suggestion  that  preferred  stock  be 
sold  to  some  of  the  personal  friends  and  acquaintances  of  the 
president  of  the  agency.  In  order  to  make  the  stock  attractive, 
however,  it  was  found  desirable  to  give  it  a  participating  fea- 
ture, which  would  make  the  possible  net  earnings  run  as  high 
as  25%.  Under  these  conditions  the  stock  was  sold.  It  is, 
however,  rather  an  unusual  instance  of  raising  cash  by  sales  of 
securities,  for  an  enterprise  in  which  personality  plays  so 
prominent  a  part. 


228  SECURING   CAPITAL 

Simplicity  Desirable 

The  successful  financial  plan  is  not  usually  one  that  is 
highly  involved  and  full  of  unusual  and  supposedly  ingenious 
little  expedients.  It  is  more  likely  to  be  simple  and  to  look 
beyond  the  needs  of  the  moment.  The  chief  financial  virtue 
is  foresight.  Hit-or-miss  financing  is  almost  certain  to  involve 
either  waste  or  danger. 

We  will  see  this  exemplified  over  and  over  again  in  dis- 
cussing the  tangled  affairs  of  insolvent  corporations  which  are 
in  process  of  reorganization.  One  of  the  noteworthy  advan- 
tages of  most  reorganizations  is  the  greater  simplicity  which 
is  secured  through  refunding  small  and  isolated  issues  into  a 
few  large  issues  with  well-defined  claims. 

It  is  usually  best,  also,  to  work  along  conventional  lines. 
Originality  is  only  too  apt  to  arouse  distrust.  There  is  almost 
an  established  routine  in  organizing  public  utility  corporations, 
which  is  about  as  follows :  First  mortgage  5  %  bonds  are 
issued  up  to  75  to  80%  of  the  cost  of  construction  or,  if  the 
company  is  a  consolidation,  of  the  value  of  the  combined  fixed 
assets.  These  bonds  sell  to  bankers  at  95  to  100.  7%  pre- 
ferred shares  are  then  issued  for  the  balance  of  the  tangible 
assets  plus  a  reasonable  amount  of  good-will.  It  is  expected 
that  the  preferred  shares  will  be  able  to  keep  up  their  divi- 
dends. They  are  usually  taken  by  bankers  at  about  95. 
Common  stock  is  then  issued  to  such  an  amount  that  the  re- 
maining earnings,  after  the  period  of  development  is  over, 
will  be  sufficient  to  pay  at  least  4  or  5%.  This  would  be  con- 
sidered a  conservative  method  of  capitalization,  and  in  fact  it| 
would  be  difficult  to  suggest  any  striking  improvement. 


CHAPTER    X 

PROMOTION 

Three  Steps  in  Promotion 

After  a  financial  plan  has  been  formed  and  agreed  upon 
by  all  parties  interested,  the  next  step  is  to  put  it  into  opera- 
tion. If  the  only  persons  who  are  to  be  identified  with  the 
new  enterprise  are  those  who  have  talked  it  over  among  them- 
selves and  come  to  a  decision  as  to  the  plan,  there  can  hardly 
be  said  to  be  a  separate  process  of  persuading  them  to  accept 
the  plan  and  to  purchase  the  securities  of  the  new  enterprise. 
But,  when  an  enterprise  is  large  enough  to  necessitate  the 
seeking  of  capital  outside  the  original  circle,  then  there  is  a 
distinct  <;tagp  rvF^^^ping  the  proposition  into  salable  form  and 
of  raising  the  required  capital  through  the  sale  of  securities. 
which  process  is  known  as  ''promotion*'* 

~~As  to  the  legitimacy  and  usefulness  of  the  promotion  of 
sound  and  beneficial  enterprises  there  can  be  no  real  question. 
The  promoter  finds  an  opportunity  and  turns  it  into  a  reality. 
His  work  has  been  in  part  discredited  because  the  term  "pro- 
motion" has  been  misapplied  to  many  swindling  efforts  to  sell 
worthless  stock.  In  its  proper  meaning,  however,  it  should  be 
a  term  of  honor.  Thejiromoter  is  thg^^rganizer  who  brings 
together  capital  and  an  enterprise  in  which  capital  can  be  use- 
ftitly-tmd  profitably  employed.  ""^  " 

If  promotion  is  carried  on  properly,  it  is  divisible  into 
three  distinct  stages.  .Fjist^comes  the  thorough  investigation 
of  the  new  enterprise  in  all  its  phases.  Sometimes  the  pro- 
moter is  so  familiar  with  the  enterprise  that  this  stage  may 
be  almost  overlooked;  more  frequently,  he  possesses  merely  a 

229 


230  SECURING   CAPITAL 

general  knowledge  of  similar  enterprises,  which  knowledge 
enables  him  readily  to  grasp  the  particular  enterprise  before 
him.  It  is  dangerous,  however,  for  him  to  make  any  assump- 
tions without  full  and  accurate  verification.  The  ne^  step  in 
promotion  is  the  so-called  "assembling"  of  the  enterprise,  that 
is  to  say,  forming  the  financial  plan,  securmg  options,  chaxt^r- 
ing  the  new  corporation,  and  otherwise  making  the  final  prepa- 
rations for  selling  securities.  The  third  step  is  the  financing 
of  the  new  enterprise,  that  is,  the  actual  selling  of  the  securi- 
ties for  sufficient  capital  to  establish  the  business. 

Stages  of  Investigation 

The  investigation  of  a  proposed  new  enterprise  may  be 
divided  into  three  stages : 

1.  A  prelnninary  analysis  and  review  of  the  field  in  which 
many  approximate  tests  of  the  probable  revenue  and_ex2endj^ 
tures  may  be  applied.  Sometimes  an  hour  or  two  of  careful 
figuring  and  thinking,  based  upon  a  general  knowledge  of 
the  proposition,  will  determine  whether  it  is  worth  while  to 
proceed  with  further  study. 

2.  The  next  stage  is  a  preliminary  study  of  the  important 
facts,  corresponding  to  the  preliminary^^rvey  Ot  a  n^w  rail- 
road  line,  which  maps  out  its  course  but  does  not  attempt  to 
cover  all  the  details.  It  should  be  possible  at  the  conclusion 
of  this  stage  to  form  a  final  judgment  as  to  the  prospects  of 
the  enterprise. 

3.  Finally  there  should  come  a  detailed  investigation  of 
the  location  of  the  enterprise,  the  sales  markets,  the  personnel 
or  proposed  personnel,  and  of  numerous  other  factors,  with  a 
view  to  making  certain  that  no  hidden  weakness  exists. 

This  is  the  process  that  would  be  gone  through  in  making 
a  thorough  investigation  of  an  entirely  new  proposition,  as 
for  instance,  an  interurban  railway.  First,  anyone  considering 
the  promotion  of  the  railway  would  get  general  data  as  to  the 


PROMOTION  231 

population  of  the  territory,  length  of  the  line,  expense  of  build- 
ings, operation,  etc.,  and  would  determine  whether  it  was 
desirable  to  go  ahead.  Second,  he  would  have  a  definite  sur- 
vey and  study  of  the  traffic  possibilities  made  for  him.  Third, 
he  would  go  into  detail  as  to  the  layout  of  the  line,  the  cost  of 
right  of  way,  the  nature  and  cost  of  the  franchise,  and  so  on. 

Thoroughness  in  Investigation 

Most  promoters,  however,  have  to  do,  not  with  entirely 
new  enterprises,  but  with  readjustments  or  combinations  of 
old  enterprises;  consequently,  some  of  the  processes  of 
investigation  may  be  eliminated.  The  common  tendency  is 
to  slur  over  all  of  it,  and  the  common  result  is  that  calcula- 
tions of  prospective  earnings,  of  the  amount  of  capital 
required  and  the  like,  are  frequently  far  removed  from  the 
truth.  This  is  just  the  point  at  which  slipshod  methods  do 
most  harm. 

Frequently  the  most  casual  incidents,  supplemented  per- 
haps by  a  little  additional  thought  and  some  feeble  investi- 
gation, furnish  the  sole  basis  of  knowledge  for  an  enormous 
investment  of  capital.  The  formation  of  the  American 
Malting  Company,  in  1897,  was  the  outgrowth  of  an  acci- 
dental suggestion  to  one  of  the  large  malters  "during  a  con- 
versation held  while  crossing  Boston  Common." 

At  the  time  of  the  formation  of  the  United  States  Ship- 
building Company,  in  1902,  President  LeRoy  Dresser,  of  the 
Trust  Company  of  the  Republic,  was,  one  day,  lunching  with 
Lewis  Nixon  when  Charles  M.  Schwab  happened  to  stop  at 
the  table  and  remarked:  "Why  don't  you  buy  the  Bethlehem 
plant  ?"  Less  than  three  weeks  later  Mr.  Schwab  had  agreed 
to  turn  over  the  stock  of  the  Bethlehem  plant  to  the  Ship- 
building Company  for  $10,000,000'  collateral  trust  bonds, 
$10,000,000  preferred  and  $10,000,000  common  stock. 

The  formation  of  the  American  Bicycle  Company  in  1898 


232  SECURING   CAPITAL 

resulted  from  a  chance  remark  made  by  Colonel  J.  J.  McCook, 
a  prominent  lawyer,  to  A.  G.  Spalding,  a  manufacturer  of 
bicycles. 

"Have  you  observed  the  movement  toward  combina- 
tions apparent  everywhere?"  asked  Colonel  McCook. 

"Yes,"  replied  Mr.  Spalding. 

"Have  you  ever  thought  of  the  possible  application 
of  the  combination  idea  to  the  bicycle  industry?" 

"Not  seriously." 

"I  wish  you  would  think  it  over;  it  seems  to  be  work- 
ing in  many  cases."* 

Preliminary  Analysis 

The  preliminary  analysis  and  review  of  the  underlying 
conditions  has  been  best  standardized,  perhaps,  in  public  utility 
fields.  A  great  number  of  projects  of  this  nature  have  been 
presented  during  the  last  two  decades,  and  bankers  have 
worked  out  and  come  to  accept  certain  well-defined  standards. 
They  know,  for  instance,  the  approximate  amount  of  gross 
earnings  which  can  be  expected  from  a  given  population. 
Their  preliminary  estimates  of  earnings  are  based  upon 
approximately  the  following  probable  yearly  receipts,  from 
each  person  in  the  territory  covered  by  the  public  utility  if 

Electric  light  and  power  com- 
panies,         $3-00  to  $6.00  per  capita 

Gas  companies,    2.00  "    6.00    "        " 

Electric  street  railways  in  small 

cities, 4.00  "     5.00    "       " 

Electric  street  railways  in  large 

cities,   7.00 "  10.00    "       " 

Interurban  railways,  6.00  "  10.00   "       " 

The  New  York  Annalist  describes  the  preliminary  survey 
of  electrical  railway  projects  as  follows: 

*Dewing's   "Corporate   Promotions  and  Reorganizations,"  pp.   251,  272,  484. 
fFrom    "Promotion   and   Organization   of  Public    Service   Corporations,"   by   L.   R 
Nash,  of  the  Stone  and  Webster  Engineering  Corporation. 


PROMOTION 

There  are  25  or  30  banking  houses  in  New  York  City 
that  specialize  in  financing  electrical  railways.  Each  of 
thenr  is  supposed  to  receive  500  to  1,000  proposals  for 
building  new  lines  or  purchasing  and  rehabilitating  old 
lines  each  year. 

In  judging  these  new  projects,  the  bankers  take  into 
consideration,  first  of  all,  the  political  attitude  of  the  state 
or  city  in  regard  to  public  utilities.  They  have  on  file 
tabulated  data  with  regard  to  the  political  record  and 
activitiCwS  of  each  state.  They  consider,  next,  the  United 
States  census  figures  of  population  and  statistics,  which 
indicate  the  rate  of  growth  of  population. 

Next,  the  promoter  is  asked  to  pay  the  expenses  and  fees 
of  an  expert  engineer  designated  by  the  banking  house, 
who  makes  a  preliminary  survey  of  the  proposed  line. 
He  tabulates  the  number  of  cuts  and  fills  and  arrives  at 
an  approximate  estimate  of  the  cost  of  construction.  He 
also  inquires  closely  into  the  cost  of  rights  of  way  and  of 
terminals.  His  advance  estimates  of  cost  of  construction 
and  operation  are  generally  expected  to  come  within  5% 
of  the  actual  figures. 

This  preliminary  report  is  then  checked  against  the 
previous  experience  of  the  house.  They  add  to  the  cost 
of  construction  the  carrying  charges  on  the  investment 
before  it  begins  to  make  any  return.  They  may  get  bids 
on  the  construction  of  power  plants.  This  office  analysis 
and  checking  is  expected  to  result  in  very  accurate  esti- 
mates of  gross  earnings  and  of  outgo. 

Some  bankers  decline  to  take  up  any  such  propositions 
unless  advance  estimates  show  net  interest  earnings  equal 
to  two  and  one-half  times  the  interest  charges  on  the 
bonds  that  will  be  necessary.  Each  mile  of  track  should 
earn  a  minimum  of  $5,000,  which  is  a  generally  accepted 
figure    for   interurban    roads. 

If  the  operating  cost  is  60%,  this  leaves  net  earnings 
of  $2,000.  If  the  construction  cost  is  $25,000,  all  provided 
by  bonds  at  5%,  the  interest  charges  per  mile  are  $1,250, 
leaving  $750  per  mile  to  provide  for  depreciation,  unex- 
pected losses,  and  accidents. 

A  population  per  mile  in  a  strip  two  miles  wide  on 


233 


234  SECURING   CAPITAL 

each  side  of  the  road  of  one  thousand  is  considered  a 
safe  minimum.  The  interurban  railroad  which  exists 
mostly  on  paper  is  not  in  large  favor,  as  it  is  believed  that 
most  of  the  choice  locations  have  been  occupied.* 

Investing  Upon  an  Uncertainty 

By  way  of  contrast  with  the  care  and  the  foresight 
exercised  in  estimating  the  possibilities  of  public  utility 
propositions,  as  shown  in  the  above  quotation,  take  the 
experience  of  the  Canadian  Sardine  Company  which  some 
years  ago  put  up  a  half-million  dollar  plant  at  St.  John,  New 
Brunswick.  The  plant  was  thoroughly  modern  and  efficient 
and  was  expected  to  yield  large  profits.  Unfortunately,  there 
was  a  period  of  two  or  three  years  after  the  completion  of 
the  plant  when  the  sardines  did  not  run.  It  was  impossible 
to  carry  on  the  business  and  the  company  went  into  bank- 
ruptcy. Shortly  thereafter,  the  sardines  returned  to  the  New- 
foundland fishing  banks,  but  it  was  then  too  late.  This  is 
a  striking,  but  by  no  means  extreme,  instance  of  establishing 
a  business  and  investing  a  large  sum  of  money  upon  an 
uncertainty.  It  is  precisely  what  careful,  preliminary  investi- 
gation will  avoid  or  at  least  minimize. 

Scope  of  Iirgestigation 

We  cannot  here  enter  into  a  discussion  of  the  technical 
points  and  subjects  which  are  covered  in  the  investigations 
of  many  different  projects,  for  their  range  is  infinite.  A 
well-known  engineering  firm  has  had  under  consideration 
within  the  last  two  years  such  various  projects  as:  irrigation 
work  in  Brazil;  a  steam  railroad  in  the  Philippines;  a  street 
railway  in  South  Africa;  and  hundreds  of  proposals  within 
the  United  States.  Every  one  of  these  proposals  that  seems 
worth  while  is  reported  upon  at  great  length  by  a  trained 
engineer  and  investigator.     The  stock  of  information  which 


*New  York  Annalist,  July  20,   1914. 


PROMOTION  235 

is  included  in  the  reports  filed  with  the  head  office  of  this 
firm  is  enormous.  It  includes  many  studies  of  sociological 
and  political  conditions,  as  well  as  of  more  technical  con- 
siderations of  construction  and  engineering.  Each  one  of  the 
more  elaborate  reports  is  well  illustrated  with  photographs 
pasted  into  the  typewritten  pages.  Often  a  report  will  run 
from  50,000  to  200,000  words  and  yet  will  contain  only 
essential  information  boiled  down  to  as  brief  a  space  as 
possible. 

Some  general  statements  as  to  questions  to  be  considered 
in  an  investigation  are  included  in  a  paper  on  "Initial 
Financing  of  an  Enterprise"  by  E.  K.  Chapman,  president  of 
the  Hudson  Trust  Company  of  New  York  City,  which  was 
read  at  a  meeting  of  the  Efficiency  Society  in  March  19 14. 
According  to  Mr.  Chapman,  in  promoting  a  corporation  which 
is  taking  over  either  tangible  property  or  patent  rights,  copy- 
rights, good-will,  and  the  like,  there  are  eight  points  which 
should  receive  careful  consideration  at  the  outset. 


1.  The  validity   of  the   patents,   copyrights,   and   other 

titles  and  rights,  or  the  soundness  of  the  claim  of 
good-will. 

2.  Strength  and  dangers  of  present  and  potential  com- 

petition. 

3.  Likelihood  of  securing   for    the  new  company  the 

proper  grade  of  managerial  talent. 

4.  Sufficiency  of  capital  and  dependable  resources;  this 

should  be  enough,  not  merely  to  get  along  if  every- 
thing goes  well,  but  to  include  the  expenses  and 
losses  of  the  early  experimental  stage.  It  is 
generally  not  desirable  to  apply  a  second  time  to 
the  people  who  subscribed  the  original  amount  of 
capital  stock. 

5.  The  par  value  of  the  capital  shares,  which  should  be 


236  SECURING   CAPITAL 

low  if  the  appeal  Is  to  be  made  to  small  investors, 
and  not  less  than  $100  if  the  appeal  is  to  be  made 
to  large  investors. 
The  contract  between  the  corporation  and  the  pro- 
moter; the  promoter  should  be  reimbursed  in  cash 
for  his  actual  cash  expenditures,  but  the  compensa- 
tion for  his  services  should  be  in  the  form  of  shares 
in  the  corporation. 

7.  Necessity  of  investing  a  large  sum  of  capital  in  con- 
structing a  plant  for  manufacturing  the  proposed 
product ;  ordinarily  it  is  less  risky  to  start  by  having 
the  product  manufactured  under  contract  by  out- 
siders or  by  assembling  the  parts  which  have  been 
manufactured  under  contract. 

8.  Probability  of  securing  capital  from  men  with  experi- 
{  ence  in  similar  lines  of  business  or  with  special 

information. 

It  is  well  for  a  banker,  or  investor,  or  anyone  else  who 
has  to  do  with  financing  new  enterprises,  to  have  some  such 
list  as  Mr.  Chapman's  before  him  in  order  to  make  sure  he 
is  not  overlooking  any  essential  point.  It  may  be  of  some 
value  to  comment  briefly  on  a  few  cases  in  which  the  writer 
was  called  upon  to  make  a  preliminary  analysis  and  to  indicate 
what  information  ought  to  be  had. 

A  Simple  Example 

A  proposal  which  was  brought  up  for  criticism  some  time 
ago,  was  to  form  a  new  company  which  should  build  a 
modern  ice  cream  plant,  with  the  latest  labor-saving  devices 
and  the  best  methods  for  the  manufacture  of  pure  ice  cream, 
with  a  capacity  of  3,000  gallons  per  day,  in  the  vicinity  of  an 
important  southern  city.  Among  the  more  important  ques- 
tions on  which  exact  information  should  be  secured,  it  was 
suggested,  were  the  following: 


PROMOTION 


237 


What  is  to  be  the  cash  investment  in  real  estate?    In 

machinery  ?    In  horses,  wagons,  and  other  equipment  ? 
Will  it  be  necessary  to  extend  credit  to  any  considerable 

extent  to  your  customers?     Is  there  likely  to  be  any 

trouble  with  collections? 
How  much  do  you  expect  to  borrow  on  mortgage? 

How  much  do  you  expect  to  borrow  from  banks? 

How  large  will  your  accounts  payable  normally  be 

and  what  will  be  the  average  terms  of  payment? 
What  working  capital  in  addition  to  your  permanent 

investment  in  buildings  and  equipment  are  you  pro- 
viding for? 
What  is  to  be  the  capitalization  of  the  company?    What 

kinds  of  stock  and  notes  or  bonds  are  to  be  issued? 
Are  you  sure  of  getting  excellent  management? 
Has  provision  been  made  for  repairs  to  machinery,  fuel, 

light,    office    equipment    and    supplies,    drivers    and 

helpers,  etc.? 
Will   the    estimated   volume    of    sales    in    practice   be 

obtained    without    prohibitive    expense?      At    what 

expense  ? 
What  is  the  earning  power  of  the  corporation  likely  to 

be    after    deducting   all    selling    and    administrative 

expenses  ? 

A  Complex  Instance 

I  A  proposal  of  more  complexity  came  from  a  southern 
state  in  which  it  was  planned  to  build  a  railroad  of  less  than 
30  miles  through  three  prosperous  villages  and  opening  up  a 
rich  agricultural  and  lumber  country  to  Port  "D"  and  the  sea. 
Some  information  was  furnished  by  the  intending  promoter 
of  this  project,  but  the  data  as  at  first  submitted  was  so  incom- 
plete that  it  was  necessary  to  draw  up  a  list  of  definite  ques- 
tions, which  are  given  below,  with  a  view  to  securing  such 


238  SECURING   CAPITAL 

information  as  would  be  at  once  required  by  a  banker  or 
bond  dealer  if  he  were  to  look  into  the  proposition  at  all. 

1.  How  much  traffic  is  now  hauled  by  existing  trans- 

portation agencies  in  this  region  ? 

2.  How  much  standing  lumber  will  be  made  available 

for  shipment  by  this  new  road  ?  X 

3.  What  are  the  important  markets  for  this  lumber? 

4.  At   what  price  can  it  probably  be   sold   in  these 

markets  ? 

5.  What,  approximately,  will  be  the  cost  of  cutting  and 

of  hauling  lumber  to  railroad  and  loading  on  cars? 
(Answers  to  the  above  questions  will  give  a  basis 
for  figuring  the  possible  rates  on  lumber  from 
the  point  of  loading  to  the  markets.) 

6.  Just  how  much  rail  and  water  traffic  through  "D'* 

is  in  sight? 

7.  What  advantages  as  a  port  for  rail  and  water  traffic 

will  Port  "D"  have  over  competing  ports? 

8.  What  inducements  can  be  offered  which  will  lead  to 

the  diversion  of  traffic  now  moving  through  com- 
peting ports  to  the  route  through  Port  "D"? 

9.  At  what  rates  does  traffic  now  move  through  com- 

peting ports  to  and  from  the  markets  which  the 
promoter  hopes  to  reach  by  his  proposed  route? 
10.  What  is  the  attitude  of  connecting  rail  and  water 
lines?  Will  they  be  inclined  to  assist  in  the 
development  of  Port  "D"  or  will  they  find  it  to 
their  interest  rather  to  discourage  the  growth  of 
this  port?  (This  is,  perhaps,  the  most  important 
question  of  all,  for  a  short  railroad,  such  as  the 
promoter  has  in  view,  could  scarcely  exist,  let 
alone  thrive,  unless  it  has  the  cordial  co-operation 
of  connecting  lines.) 


PROMOTION 


239 


11.  Assuming  that  connecting  lines  are  friendly,  what 

rate  per  ton-mile  can  the  proposed  railroad  prob- 
ably secure  on  the  through  traffic? 

12.  What  will  be  the  exact  cost  of  securing  the  right  of 

way  and  constructing  the  proposed  road  ? 

13.  What  will  be  the  cost  of  providing  docks  and  other 

terminal  facilities  at  Port  "D"? 

14.  Do   the  above   estimates   contemplate   providing   a 

well-built,  modern  road,  or  rather  a  temporary 
construction  which  will  have  to  be  replaced  later? 

15.  What  will  be  the  cost  of  equipment  and  of  necessary 

supplies  of  all  kinds? 

16.  Will  it  be  possible  to  secure  local  subsidies,  or  other 

assistance  ? 

17.  Does  the   promoter   have   banking  connections   on 

which  he  can  rely  for  assistance  in  floating  the 
securities  of  the  proposed  road? 

18.  Does  the  promoter  know  any  capitalists  who  will 

probably  be  willing — provided  satisfactory  an- 
swers to  all  the  above  questions  are  given — to  buy 
the  stock  issues  of  the  proposed  road? 

19.  Is  the  promoter  able  and  willing  to  incur  the  large 

expense  that  will  be  necessary  to  secure  correct, 
dependable  answers  to  all  the  above  questions  ? 

The  process  of  securing  answers  to  the  questions  above 
listed  would  in  each  case  probably  bring  to  light  many  addi- 
tional questions  requiring  investigation.  Just  what  these 
questions  may  be  could  not  very  well  be  determined  \n  ad- 
vance, inasmuch  as  they  would  result  in  part  from  the  local 
conditions  under  which  the  project  is  to  be  established.  By 
working  out  a  list  of  questions  in  their  logical  sequence  and  by 
getting  the  most  complete  and  trustworthy  answers  possible, 
the  promoter  may  be  certain  that  he  is  leaving  nothing  of  great 


240 


SECURING   CAPITAL 


importance  uncovered.  To  be  sure,  there  may  be  unfortunate 
slips  and  omissions  even  in  the  most  thorough  investigations, 
but  they  will  generally  be  found  to  be  due  to  peculiarities  of 
the  business  or  of  the  locality  in  which  it  is  carried  on  which 
escape  the  eyes  of  a  stranger.  For  this  reason  it  is  always 
very  desirable  that  the  investigator  should  associate  himself 
as  closely  as  possible  with  a  man  who  is  thoroughly  familiar, 
by  long  experience,  with  the  peculiarities  of  the  project. 

"Assembling"  a  Proposition 

As  an  illustration  of  the  casual  way  in  which  people  some- 
times take  a  hand  in  promoting  new  enterprises,  a  case  was 
reported  recently  of  a  manufacturer,  whom  we  will  designate 
as  A,  who  was  desirous  of  joining  forces  with  a  certain  large 
corporation  or  of  selling  out  to  it.  He  came  into  contact  with 
a  broker  and  promoter,  B,  who  was  acquainted  with  a  second 
promoter,  C,  who  had  facilities,  in  B's  opinion,  for  putting 
through  just  the  deal  that  A  had  in  mind.  B  took  A  over  to 
C's  office,  introduced  him  and  explained  that  in  view  of  C's 
facilities  he  would  step  out  of  the  transaction,  expecting,  how- 
ever, to  be  taken  care  of  in  case  the  deal  were  consummated. 
Later  the  transaction  was  actually  effected  and  the  question 
immediately  arose  as  to  what  compensation  B  ought  to  obtain. 

There  is  no  such  thing  as  a  standard  rate  or  a  standard 
method  of  fixing  the  compensation  for  financial  promoters, 
and  in  this  case  there  was  no  definite  bargain  in  advance.  B 
could  certainly  have  no  legal  claim,  inasmuch  as  he  had  per- 
formed no  service,  and  it  is  questionable  if  he  would  have  any 
moral  claim  except  for  a  small  honorarium.  A  mere  sugges- 
tion or  an  introduction  can  hardly  be  claimed  to  have  a  high 
commercial  value.  Yet  B  from  his  point  of  view  might  well 
reason  that,  without  him,  A  would  probably  not  have  made 
the  deal  which  was  so  profitable  to  him,  and  that  B  conse- 
quently was  fairly  entitled  to  a  large  proportion  of  these  prof- 


PROMOTION 


241 


its.  The  question  can  never  be  answered  one  way  or  the  other 
to  the  satisfaction  of  both  parties.  It  is  clear  that  it  should 
never  have  been  allowed  to  arise.  B  was  careless  and  unbusi- 
nesslike in  his  dealings.  If  he  thought  there  was  any  reason- 
able chance  of  putting  through  the  transaction,  he  should  have 
arranged  with  C  for  a  definite  proportion  of  his  commission. 
Evidently,  under  the  definition  that  has  previously  been  given, 
B  did  not  have  in  this  case  a  properly  ''assembled"  proposition. 

Another  case  in  which,  according  to  the  promoter's  own 
story  he  failed  to  give  himself  proper  protection,  came  into  the 
New  Jersey  courts  a  few  years  ago,  and  was  decided  by  the 
Court  of  Errors  and  Appeals  in  191 2.  It  appears  that  Harry 
C.  Haskins  claims  to  have  been  the  originator  of  the  scheme  to 
unite  all  the  independent  lead  companies  not  previously  in- 
cluded in  the  National  Lead  Company.  He  went  to  Thomas 
F.  Ryan,  the  well-known  financier,  and  enlisted  his  support. 
Mr.  Haskins  charges  that  after  Mr.  Ryan  and  his  friends  had 
secured  from  him  all  the  information  they  needed,  and  had 
made  use  of  his  knowledge  of  the  lead  business,  resulting  from 
years  of  study,  they  froze  him  out  of  the  deal.  His  claim  was 
that,  while  Mr.  Ryan  had  made  enormous  profits  as  promoter 
of  the  consolidation,  he  himself  had  received  nothing. 

Without  attempting  to  express  any  opinion  whatever  on 
the  merits  of  this  case,  it  is  plain  that  in  the  eyes  of  the  law 
Mr.  Haskins  could  have  little  standing.  He  had  no  property 
right  in  the  idea  of  forming  the  consolidation;  the  facts  and 
figures  which  he  submitted  to  Mr.  Ryan  were  apparently 
freely  given.  He  may  have  had  a  verbal  understanding,  but, 
if  so,  it  can  best  be  described  as  an  agreement  to  make  an  agree- 
ment, fulfilment  of  which  cannot,  of  course,  be  compelled  in 
equity  proceedings.  In  other  words,  the  original  promoter, 
Mr.  Haskins,  according  to  his  own  statement,  did  not  con- 
tractually protect  himself.  He  went  ahead  before  he  had 
"assembled"  his  proposition. 


242 


SECURING   CAPITAL 


Protection  of  Promoter 

Much  the  same  thing  has  happened  over  and  over  again 
in  organizing  combinations.  A  promoter  may  get  the  idea  of 
bringing  certain  companies  together  and  may  start  talking  ^rst 
with  one  manufacturer  and  then  with  another;  in  a  short  time 
he  finds  that  the  idea  is  being  generally  discussed  and  that  the 
manufacturers  are  talking  direct  with  each  other.  A  little  later, 
if  the  whole  plan  looks  sound  and  attractive  to  them,  they  ire 
very  likely  to  come  together  almost  of  their  own  accord  or 
through  the  efforts  of  some  of  their  lawyers  or  of  some  other 
person  besides  the  original  promoter.  Unless  the  promoter  is 
himself  a  man  of  such  personal  acquaintanceship  and  force 
that  his  assistance  is  a  positive  and  essential  factor  in  forming 
the  combination,  it  is  almost  certain  that  his  claims  to  com- 
pensation will  get  very  slight  consideration.  No  one  among 
the  manufacturers  can  undertake  to  lock  after  the  promoter's 
personal  interest;  he  is  supposed  to  do  that  for  himself.  The 
only  method  he  can  successfully  follow  is  to  secure  contracts 
or  options  which  will  put  him  in  a  position  of  distinct  legal 
advantage.  When  he  has  secured  these  contracts  or  options, 
then,  and  not  till  then,  his  proposition  is  assembled. 

Purchase  Outright 

If  the  promoters  and  the  financiers  working  with  them  are^ 
well  supplied  with  cash,  their  problem  rriay  be  much  simpli- 
fied.   In  the  promotion  of  the  Mount  Vernon- Woodberry  Coti 
ton  Duck  Company  in  Baltimore,  1899,  the  promoters  acquirec 
fourteen  mills  by  making  a  separate  bargain  with  each  manu^ 
facturer  and  paying  to  him  an  agreed  price  in  cash.    The  pric< 
fixed  with  one  manufacturer  was  not  known  to  the  others 
In  working  under  this  method  the  promoters  were,  of  course^ 
assuming  a  large  personal  risk  which  it  is  frequently  impossible 
for  the  organizer  of  a  large  combination  to  take  upon  himseli 

The  next 'most  secure  plan  is  to  persuade  each  concert 


PROMOTION 


243 


that  is  to  be  taken  into  the  combination,  to  grant  an  option  for 
a  limited  period  at  a  fixed  price.  After  the  promoter  has 
secured  enough  of  these  options  to  assure  the  reaHzation  of  the 
project,  he  is  then  in  position  to  form  a  definite  proposition 
and  take  it  up  with  bankers  for  the  purpose  of  securing  finan- 
cial backing.  The  methods  of  securing  options  may  differ 
in  each  case,  and  a  separate  bargain  will  in  each  case  be  driven. 
When  the  United  States  Shipbuilding  Company  was  first  pro- 
moted, in  1899,  Colonel  John  J.  McCook  and  John  W.  Young, 
the  promoters,  first  of  all  persuaded  Lewis  Nixon  to  give  an 
option  on  his  Crescent  Ship  Yard  and  adjoining  property, 
with  the  understanding  that  Mr.  Nixon  should  consent  to  act 
as  general  manager  of  the  proposed  consolidation.  In  getting 
together  such  a  proposition  as  a  new  street  railway,  it  is  often 
necessary  to  secure  option  on  rights  of  way  and  to  obtain  fran- 
chises from  the  city  and  county  authorities  in  order  to  forestall 
"hold-ups"  at  a  later  period  in  the  development  of  the  proposi- 
tion. Under  such  conditions,  these  options  must  be  obtained 
very  quietly  and  quickly. 

Sometimes  the  process  of  "assembling"  is  completed  when 
the  promoter  has  obtained  a  control  over  some  one  plant  or 
some  one  portion  of  the  contemplated  project  which  is  regarded 
as  essential.  This  control  puts  him  in  a  position  of  strategic 
advantage.  There  can  be  no  general  rule  as  to  assembling; 
the  most  that  can  be  said  is  that  the  promoter  must  put  himself 
and  keep  himself  in  a  position  of  mastery  over  the  situation. 
If  he  does  not  do  so,  he  cannot  expect,  and,  as  a  matter  of  fact, 
he  has  no  right  to  expect,  any  large  compensation  for  his  ser- 
vices. He  is  playing  his  game  on  the  implied  understanding 
that  in  case  he  obtains  a  position  of  advantage  he  will  expect 
a  large  return  for  his  services,  which  must,  in  fairness,  be  bal- 
anced by  the  understanding  that  in  case  he  finds  himself  at  a 
i disadvantage  he  will  get  very  little  return. 


244  SECURING   CAPITAL 

dealing  is  not  that  of  one  banker  or  business  associate  to 
another,  but  is  rather  that  of  buyer  and  seller  of  a  product 
which  has  no  fixed  value.  The  promoter  is  endeavoring  to 
get  the  highest  price  obtainable,  and  the  owner  of  the  property 
or  of  the  cash  that  goes  into  the  enterprise  quite  properly 
wishes  to  do  the  best  he  can  for  himself. 


Preliminary  Financing 

As  soon  as  the  promoter  starts  to  develop  a  new_proppsi- 
tion,  he  begins  to  establish — if  he  has  not  previously  done  so — 
the  banking  connections  that  will  be  of  greatest  use  in  con- 
nection with  the  enterprise.  These  connections  should  be  with 
banks  that  are  already  familiar,  through  their  own  experience, 
either  with  the  line  of  business  or  with  the  field  of  operations 
of  the  business  in  which  the  promoter  is  working.  To  be 
specific,  if  the  project  is  to  establish  an  interurban  railroad 
near  Dallas,  Texas,  the  promoter  will  look  for  his  financial 
connections  either  among  the  New  York,  Boston,  Chicago,  and 
St.  Louis  banking  houses  that  are  accustomed  to  investigating 
and  floating  interurban  properties,  or  among  the  Dallas  bankers 
who  thoroughly  know  the  local  situation  and  can  perhaps 
assist  in  raising  funds  from  local  people.  The  active  co- 
operation of  interested  bankers  is  quite  essential  to  the  success 
of  most  promotions.  The  first  stag^e  of  the  financing-  in  which 
the  banker  plays  his  partmay^be  reached  when  the  purchase 
of  options  or  the  outright  purchase  of  property  is  under  con: 
sidferation.  The  bankers  interested  may,  at  this  point,  create] 
a  syndicate  which  will  advance  money  to  the  promoter  for  thej 
purchase  of  options  on  the  property,  with  the  agreement  that 
repayment  is  to  be  max^e.  as  soon  as  the  promotion  is  success- 
fullyjQoated.  If  the  expenditure  at  this  stage  is  for  options 
only  and  the  promoter's  personal  means  should  not  allow  him 
to  go  ahead  unassisted,  he  very  likely  would  attempt  to  organ- 
ize a  small  syndicate  among  his  personal  acquaintances  whoj 


PROMOTION  245 

would  be  willing  to  share  with  him  equally  the  risks  and  the 
profits  of  the  promotion.  Ordinarily,  the  bankers  would  not 
step  in  unless  outright  purchase  on  a  large  scale  was  called  for. 

V  Thenext  stage  at  which  bankers'  co-operation  may  he 
called  for  is  during  the  period.  j:^f  development,  when  the 
promotion  involves  a  great  deal  of  construction;  or  the  period 

^of  waiting,  when  the  promotion  is  a  combination  that  can- 
not  at  once  be  financed  by  the  sale  of  securities  to  the  pttbljt:. 
Let  us  take  an  assumed  example  for  the  sake  of  clearness. 
A  new  manufacturing  company  is  to  put  up  a  plant  costing 
$1,000,000,  and  provide  machinery  and  equipment  amounting 
to  $500,000.  Let  us  assume  that  the  product  is  of  such  nature 
that  there  can  be  no  question  as  to  its  marketability.  It  may 
sometimes  be  desirable  and  possible  to  raise  the  full  amount 
of  required  capital — $1,500,000  in  this  case — at  the  outset 
and  expend  it  gradually  in  the  construction  of  the  plant, 
but  in  other  cases  this  plan  will  be  found  impracticable  and 
the  question  will  arise  as  to  how  to  secure  the  funds  with 
which  to  keep  construction  going  while  at  the  same  time 
taking  care  of  the  sale  of  securities. 

The  customar.y.,.4^Iaa_is  to  place  a  mortgage  on  the 
property  acquired  or  later  fn  he  acqiiired.  and  to  issue  bonds 
up  to  the  extent  of  the  mortgage.  These  bonds,  however, 
^^11  iTOr"be  salable  until  the  property  has  actually  been 
developed.  The  difficulty  may  best  be  met  by  depositing 
them  with  bankers  as  security  for  short-term  loans  and  using 
these  loans  to  provide  funds  for  construction.  The  banker 
receives  these  bonds  as  collateral,  which  will  eventually  be 
salable  and,  in  case  the  whole  proposition  Is  sound,  may  con- 
sider himself  at  least  fairly  well  protected.  Usually  the 
arrangement  is  that  the  bonds  shall  be  delivered  as  construc- 
tion goes  on,  so  that  the  banker  may  never  have  on  hand  a 
great  many  bonds  representing  property  that  exists  as  yet 
only  on  paper. 


246  SECURING   CAPITAL 

The  analogous  difficulty  in  case  a  combination  is  formed, 
the  securities  of  which  are  not  at  once  salable,  is  met  in  the 
same  way.  The  securities  are  posted  as  collateral  for  bank 
loans  and  the  loans  are  later  paid  off  as  the  securities  are 
disposed  of. 

By  means  of  this  preliminary  financing,  an  enterprise 
can  be  financed  even  though  the  promoter  and  his  immediate 
friends  may  have  limited  funds  up  to  the  point  when  the 
sale  of  securities  to  the  public  brings  in  the  required  amount 
of  capital. 

Foresight  in  Providing  Funds 

One  of  the  most  common  errors — and  also  one  of  the 
most  dangerous — in  organizing  a  new  corporation  is  to  start 
it  off  with  insufficient  capital  to  carry  it  through  to  success. 
The  result  is  that  the  new  corporation  perhaps  makes  a  fine 
start,  gives  promise  of  yielding  large  profits,  and  then  sud- 
denly threatens  to  collapse  because  the  supply  of  cash  has 
been  exhausted.  Credit  is  not  readily  available  for  most  new 
corporations.  The  organizers  turn  hopefully  to  the  natural 
recourse  of  selling  more  stock,  and  usually  find  themselves 
confronted  by  a  blind  wall  of  skepticism.  It  is  a  curious 
fact  that  an  entirely  new  project,  which  exists  only  as  an 
idea  and  has  not  yet  been  troubled  by  any  of  the  harsh 
vicissitudes  of  business  existence,  appeals  strongly  to  the 
imagination  and  is  generally  able  to  command  capital  with 
comparative  ease;  whereas  exactly  the  same  project  six 
months  or  a  year  later,  when  substantial  progress  has  been 
made  and  its  profitableness  has  been  in  part  demonstrated,  is 
no  longer  appealing  and  raises  new  capital  with  difficulty. 
The  reason  is  no  doubt  to  be  found  in  the  fact  that  the 
owner  of  capital  in  the  second  case  looks  at  the  project  at 
close  range,  sees  it  in  its  prosaic  realization  and  can  hardly 
conceive  it  as  a  great  money  maker.     In  the  first  place 


•dlyj 
hisi 


PROMOTION 


247 


i 


imagination  was  left  untrammeled.  Promoters  are  insistent, 
therefore,  on  one  piece  of  advice  in  which  they  all  agree: 
iiL^organizing  a  new  pntprpricp^  roi'gp  af  |Vi^  ^Mifset  all  the 
capital  required  to  bring  it  to  success. 

Working  Capital  Required 

One  difficulty  that  often  comes  up  at  this  point  is  that  of 
estimating  the  amount  of  cash  capital  required.  Ainong  ama- 
teur  promoters  the  strong  tendency  is  to  underestimate.  Even 
wITere  a  new  proposition  is  of  quite  a  definite  character — that 
is  to  say,  where  it  involves  buying  a  given  property  or  proper- 
ties at  an  agreed  price,  turning  out  a  stable  product  for  an  as- 
sured market  and  selling  it  at  a  price  known  in  advance — even 
under  such  conditions  underestimates  are  frequent.  They 
most  commonly  arise  from  two  oversights:  first,  the  neglect 
t2-2I9ji5K.SAi^ffi^^J^Qrking.xapital,  the  need  for  which  will 
be  fully  discussed  later;  second,  overlooking  the  incorpora- 
tion and_sdling  expenses  necessarily  required  to  star^  the 
corporation  and  dispose,  of  .its  capital-eteck.  Selling  expense 
oFTapitai  stock  may  run  as  high  as  25  or  30%,  although 
a  much  smaller  percentage,  dwindling  to  nothing,  is  more 
normal. 

A  typical  experience  in  organizing  a  small  corporation 
with  insufficient  financial  backing,  has  recently  been  related 
to  the  author  in  the  following  terms: 

About  two  years  ago  I  was  induced  to  purchase 
stock  in  the  Smith  Manufacturing  Company,*  which 
owned  the  patents  and  intended  to  manufacture  and  sell 
an  office  equipment  device.  Only  one  other  person  was 
interested  and  he  took  an  equal  amount  of  stock  and  was 
to  be  the  active  man  at  $150  per  month.  It  was  nearly 
six  months  before  we  were  able  to  get  our  dies  con- 
structed and  sufficient  stock  on  hand  to  go  after  business, 
and  this  work  took  a  lot  more  money  than  we  anticipated. 


*The  name  is  fictitious. 


248  SECURING   CAPITAL 

We  also  had  trouble  with  our  finish  and  replaced  a  lot 
of  our  devices  which  we  had  placed  in  the  first  few 
months.  Manufacturing  difficulties  were  finally  overcome 
and  we  have  had  no  other  complaints  on  that  score.  Our 
difficulty  now  is  to  market  the  product.  Sales  for  the 
year  have  been  only  about  2,500  units. 

Up  to  this  time  about  $20,000  has  gone  into  the  busi- 
ness and  as  yet  we  are  hardly  making  expenses  on  average 
monthly  sales  of  $1,000.  It  has  come  to  the  point  now 
where  we  must  find  a  more  profitable  method  of  merchan- 
dising, sell  out,  or  liquidate.  We  would  prefer  to  sell  out, 
but  we  have  nothing  very  encouraging  to  offer  a  pur- 
chaser, so  it  resolves  itself  into  one  of  the  other  two.  A 
first-class  merchandising  man,  in  whom  both  of  us  feel 
confidence,  could  be  secured  if  we  were  in  position  to 
put  in  another  $10,000  so  as  to  make  sure  that  the  busi- 
ness runs  for  another  year.  Personally,  I  am  convinced 
that  with  the  right  plan  of  sale,  the  whole  project 
would  be  a  tremendous  money  maker,  but  we  haven't  the 
cash  ourselves,  don't  know  where  to  turn  for  it,  and 
haven't  much  of  a  record  to  fall  back  upon. 


y\ie  c;tr>rip<;  <»f-lQ&s- in  harjHIing  enterprises  that  are  known 
to  be  in  themselves  sound  and  profitable,  are  so  numerous, 
that  probably  every  reader  cairpick  one  or  more  out  of  his 
own  experience  or  observation.  It  will  take  very  little  analy- 
sis of  each  one  of  these  cases  to  demonstrate  that  the  loss  has 
been  due  to  carelessness  in  one  or  more  of  the  folio wiii^ 
features : 


I.    In  not  ascertaining  all  the  available  facts  in  advance] 
i  of  making  investment. 

;    2.    In  neglecting  to  clinch  the  legal  rights  of  the  organizer] 
by  means  of  contracts,  options,  or  the  outright  pur- 
chase of  some  of  the  essential  property. 
3.    In  failing  to  establish  close  relations  with  financij 
I  houses  which  would  be  of  assistance  in  carrying  th( 


PROMOTION 


249 


enterprise  through  the  construction  stage  and  up  to 
the  point  where  securities  could  be  sold  as  the  issues 
of  an  established  concern. 
4.  In  making  insufficient  estimates  of  capital  require- 
ments, having  in  view  not  only  fixed  capital,  but 
also  working  capital  and  the  necessary  expenses  of 
selling  securities. 

All  these  errors  with  a  little  judgment  and  foresight  are 
easily  avoidable. 


CHAPTER    XI 

THE    PROMOTER 

Professional  Promoters 

As  noted  in  the  preceding  chapter,  the  word  ^'promoter" 
has  come  to  be  associated  with  Colonel  Sellers  and  J.  Rufus 
Wallingford,  and  consequently  is  commonly  regarded  as  a 
term  of  reproach  rather  than  of  praise.  Yet,  when  it  is  used 
in  its  proper  sense,  it  indicates  a  man  of  exceptional  energy 
and  foresight  who  is  able  to  conceive  a  new  enterprise  and  to 
set  it  on  its  feet.  He  belongs  to  the  class  of  men  who  make 
for  progress. 

One  unfavorable  connotation  for  the  word  comes  out  of 
the  expression,  "professional  promoter."  Each  one  of" the  two 
words  in  the  expression  is  innocent  in  itself,  but  where  they 
are  combined  they  seem  to  imply  an  individual  who  is  making 
his  money  by  his  wits  at  the  expense  of  dupes.  There,  is  un- 
doubtedly some  truth  in  this  implication,  for  a  certain  group 
of  semicriminals  who  call  themselves  brokers  and  promoters 
make  it  their  business  to  prey  upon  struggling  enterprises  and 
defraud  them  while  they  pretend  to  assist  them. 

Yet,  there  are  some  men  of  excellent  standing  to  whom 
the  term  "professional  promoter,"  if  used  in  its  correct  sense, 
could  properly  be  applied.  Dewing  mentions,  among  other 
men  of  this  type,  Charles  M.  Warner,  who  took  part  in  promo- 
tions so  widely  separated  as  the  American  Malting  Company, 
the  Corn  Products  Refining  Company,  the  Bay  State  Cotton 
Corporation,  the  International  Cotton  Mills  Corporation,  and 
the  National  Asphalt  Company.  He  mentions,  also,  Seymour 
Scott,  a  small  maltster  of  Lyons,  N.  Y.,  whom  he  describes  as 
"a  man  of  great  optimism  and  emotional  enthusiasm  who  later 

250 


THE   PROMOTER 


251 


promoted  another  successful  combination  and  still  later  became 
interested  in  the  promotion  of  some  beet  sugar  plants,  hypothe- 
cated his  holdings  of  American  Malting  Company  stock  in 
order  to  raise  money  and  lost  all  of  it  with  the  failure  of  the 
beet  sugar  concern."* 

The  phrase  quoted  in  the  preceding  paragraph,  "great 
optimism  and  emotional  enthusiasm,"  is  a  happy  characteriza- 
tion of  a  certain  type  of  professional  promoter.  He  is  the 
type  who  sees  visions  and  sweeps  hard-headed  business  men 
into  the  current  of  his  own  enthusiasm.  The  other  type  of 
promoter  is  the  clever  schemer — not  necessarily  dishonest— 
who  pits  men  and  interests  against  each  other,  or  hitches  them 
into  partnersl]ips,  relying  not  so  much  on  the  contagion  of  his 
own  enthusiasm  as  on  his  calculations  as  to  the  reactions  of 
men  on  each  other. 

On  the  whole,  the  professional  promoter  is  perhaps  less 
flourishing  and  a  rarer  phenomenon  than  was  the  case  ten  to 
twenty  years  ago.  There  have  not  been  so  many  large  promo- 
tions or  so  much  call  for  his  services.  His  place,  furthermore, 
is  being  taken  by  the  occasional  promoters  who  come  from 
the  following  classes : 

Local  lawyers  and  bankers 
Engineering  firms 
Business  executives 

There  is  little  to  be  said,  if  we  are  to  speak  in  general 
terms,  of  the  activities  of  local  lawyers  and  bankers  as  pro- 
moters. It  is  enough  to  call  attention  to  the  fact  that  ordinarily 
they  are  natural  leaders  in  organizing  new  local  enterprises. 
If  some  western  country  town  is  establishing  a  new  creamery 
or  a  new  cannery;  if  in  some  eastern  city  there  is  opportunity 
for  a  combination  of  small  local  manufacturing  concerns;  if 
a  man  of  inventive  talent  gets  up  a  new  device  and  begins  to 


*Dewing's   "Corporate   Promotions   and   Reorganizations,"  pp.   289,  446. 


252 


SECURING   CAPITAL 


talk  among  his  friends  as  to  the  possibiHties  of  developing  it — 
in  any  one  of  these  cases  the  opportunity  usually  comes  straight 
to  the  lawyer  or  banker  who  is  in  position  to  give  it  some  of 
his  time  and  thought  and  perhaps  to  carry  it  through  to  suc- 
cess. The  number  of  such  cases  of  local  promotions  on  a 
small  scale  is  surprising  and  probably  accounts  for  a  consider- 
able proportion  of  the  annual  crop  of  new  enterprises. 

Engineering  Firms  as  Promoters 

It  is  well  known  that  a  few  large  engineering  firms  of  high 
standing  have  organized  and  financed  and  now  manage  thou- 
sands of  street  railway  and  other  public  utility  corporations, 
especially  in  the  smaller  cities  and  towns.  Among  the  most 
important  of  these  firms  may  be  mentioned  H.  L.  Doherty 
Company,  Stone  and  Webster,  J.  G.  White  Company,  and 
H.  M.  Byllesby  and  Company.  All  of  these  firms,  it  is  stated, 
have  more  or  less  drifted  into  their  present  promotion  activi- 
ties. The  business  of  each  firm  was  primarily  to  carry  on  pro- 
fessional engineering  work.  As  they  grew  in  size  and  the 
expense  of  maintaining  a  large  staff  of  high-priced  experts 
became  a  greater  and  greater  burden,  it  was  found  necessary 
to  go  beyond  merely  seeking  profitable  work  for  these  men 
and  to  embark  upon  the  policy  of  creating  work  for  them. 
This  could  be  done  only  by  actively  organizing  and  financing 
new  corporations  with  which  the  firm  then  made  contracts  for 
engineering  service.  Promotion  at  the  beginning,  then,  was  a 
side  issue;  but  it  has  grown  and  grown  until  one,  at  least,  of 
these  firms  is  regarded  as  much  more  distinctly  a  financial 
house  than  an  engineering  firm. 

We  might  include  with  this  group  some  of  the  large  manu- 
facturing companies  which  are  actively  engaged  in  financing 
new  enterprises  with  a  view  to  obtaining  their  orders  for  ma- 
chinery and  other  equipment.  The  concern  that  has  followed 
this  policy  with  the  greatest  enterprise   and  success  is  the 


THE   PROMOTER  253 

General  Electric  Company,  which  through  its  Electric  Bond 
and  Share  Company  and  other  subsidiary  corporations  dis- 
poses of  the  securities  of  a  great  number  of  enterprises  which 
it  desires  to  see  developed. 

The  essential  feature  of  all  these  arrangements  is  that  the 
concern  which  has  services  or  a  product  to  sell  does  not  sit 
back  and  wait  with  folded  arms  until  some  one  else  has  suc- 
ceeded in  interesting  capital  and  in  building  up  the  enterprises 
which  constitute  a  market  for  their  services  or  products. 
Instead,  they  look  for  the  opportunities  where  their  services  or 
products  can  profitably  be  used,  and  then  proceed  to  promote 
the  enterprises  to  handle  the  opportunities. 

All  such  concerns,  after  this  policy  becomes  known,  are 
deluged  with  a  constant  stream  of  applications  for  their  assist- 
ance in  developing  new  enterprises  in  which  it  is  thought  they 
might  be  interested.  After  receiving  these  proposals,  those 
which  appear  to  be  worth  while  are  investigated  along  the 
lines  that  have  been  suggested  in  the  preceding  chapter.  In 
case  the  investigation  yields  a  favorable  report,  they  proceed 
to  incorporate  and  capitalize  the  new  enterprise  in  accord- 
ance with  the  principles  previously  discussed.  The  procedure 
thereafter  differs.  Some  of  the  firms  work  in  close  connection 
with  banking  houses  which  underwrite  the  securities  of  their 
corporations  and  proceed  to  sell  them  to  the  general  public. 
Other  firms  have  their  own  departments  or  subsidiary  cor- 
porations for  the  sale  of  securities,  thus  carrying  through  the 
whole  enterprise  from  its  inception  through  the  investigation, 
the  flotation,  the  construction  of  the  plant  or  property,  and 
even  beyond  this,  through  the  initial  stages  of  its  manage- 
ment. 

German  electrical  companies  follow  much  the  same  policy 
and  in  the  international  markets  work  in  direct  competition  in 
this  respect  with  American  companies.  It  is  said,  however, 
that  engineering  firms  in  other  countries  have  not  developed 


254 


SECURING   CAPITAL 


as  financial  agencies  to  anything  like  the  same  extent  as  some 
of  the  American  firms. 

Business  Executives  as  Promoters 

In  forming  combinations  among  competing  manufacturing 
plants,  it  is  not  at  all  unusual  to  find  the  initiative  coming 
from  the  manufacturers  themselves.  Sometimes  they  get 
together  and,  through  a  committee  or  through  informal  dis- 
cussion, agree  upon  a  plan  of  forming  a  new  corporation 
which  shall  take  in  all  the  previously  competing  plants.  This 
was  the  method  of  forming  the  leather,  cordage,  asphalt, 
and  glucose  combinations.  In  a  case  of  this  kind,  we  hardly 
speak  of  a  "promoter."  There  is  really  not  much  need  for 
his  services,  inasmuch  as  the  manufacturers  meet  of  their  own 
accord.  Another  situation  exists  in  some  industries  where 
there  is  keen  competition  and  possibly  some  ill-feeling,  but 
where  one  plant  or  one  individual  stands  out  as  a  recognized 
leader,  either  through  size,  enterprise,  personality,  or  other 
cause.  If  a  combination  is  to  be  formed  in  an  industry  where 
this  situation  prevails,  it  may  be  easily  possible  for  the  lead- 
ing firm  or  individual  to  become  the  promoter.  This  was 
true  in  the  case  of  the  salt,  malting,  and  bicycle  combina- 
tions. It  constitutes  a  somewhat  exceptional  case  when  a 
business  executive  or  a  group  of  executives  in  one  concern 
actually  promote  a  combination  with  their  rivals.  The  case 
is  exceptional  for  the  reason  that  no  man  easily  submits  to 
taking  a  position  of  inferiority  to  a  former  competitor*  or  to 
seeing  his  competitor,  starting  from  the  same  level  as  him- 
self, form  a  combination  and  take  a  large  block  of  promoter's 
profits.  It  is  far  easier  for  a  man  to  come  in  from  out- 
side in  order  to  carry  through  such  a  combination. 

The  customary  case  of  the  business  executive  as  a  pro- 
moter arises  in  the  formation  of  entirely  new  enterprises. 
The  man  who  takes  the  lead  in  such  enterprises,  is  com- 


THE   PROMOTER  255 

monly  the  same  man  who  expects  to  manage  them  after  they 
are  organized.  In  many  respects  this  is  the  correct  arrange- 
ment. It  obviates  the  objection  which  arises  when  the  pro- 
moter forms  a  combination  and  then  ceases  his  active  connec- 
tion with  it;  namely,  that  the  promoter  is  influenced  wholly 
by  his  desire  to  sell  stock  and  float  the  new  enterprise  and 
not  at  all  by  consideration  of  the  future  requirements  of  the 
enterprise.  On  the  other  hand,  when  the  future  manager  of 
the  enterprise  himself  promotes  it,  there  is  the  corresponding 
danger  that  he  will  overlook  its  financial  needs  while  secur- 
ing his  capital — if  he  is  successful  in  getting  it  on  any  terms 
— by  unnecessarily  crude  and  wasteful  methods.  To  be  sure, 
the  resulting  loss  is  chiefly  in  the  prospective  profits  of  the 
promoter  himself,  so  that  no  one  else  is  likely  to  object. 
However,  in  the  interests  of  men  of  this  type,  a  few  remarks 
as  to  points  which  they  should  watch  in  forming  their  financial 
plan  will  not  be  out  of  place. 

The  Promoter's  Financial  Plan 

First  of  all,  it  is  necessary  that  sufficient  capital  should 
be  raised  or  authorized;  yet,  on  the  other  hand,  it  is  desir- 
able, if  the  period  of  construction  and  development  is  to  be 
lengthy,  that  the  sale  of  securities  should  be  postponed  until 
the  corporation  is  actually  on  its  feet.  There  may  seem  to 
be  at  first  glance  no  possibility  of  reconciling  these  two  con- 
flicting requirements.  The  solution  to  this  problem  is  to  be 
found  in  making  such  connections  with  banking  houses  that 
they  will  be  willing  to  carry  through  the  preliminary  financing 
and  underwrite  the  sale  of  the  securities  of  the  completed 
proposition.  This  is  one  of  the  devices  universally  used  in 
large  enterprises,  but  seldom  in  small  ones.  There  is  no  rea- 
son, however,  why  it  should  not  be  almost  equally  well  adapted 
to  the  small  concern  which  through  the  local  bankers  may 
cure  accommodation  on  the  strength  of  its  own  securities  as 


I 


256  SECURING    CAPITAL 

collateral  and  may  later  sell  those  securities  and  repay  the 
bank  loan. 

A  second  point  to  notice  is  that  the  promoter  should  pro- 
tect his  own  interests,  for  he  may  be  sure  that  no  one  else 
will  do  this  for  him.  The  proper  method  of  taking  care  of 
himself  is  to  raise  all  the  capital  that  is  needed,  on  as  good 
terms  as  possible,  by  the  sale  of  bonds,  preferred  shares, 
and  common  shares,  retaining  for  himself  the  remaining 
equity  in  the  business.  This  is  the  place  where  many  busi- 
ness executives,  as  promoters,  fail  to  realize  the  full  returns 
to  which  they  are  entitled.  They  are  likely  to  put  in  their 
own  money  under  precisely  the  same  conditions  as  the  money 
of  other  people,  without  reserving  for  themselves  the  equit- 
able interest  which  belongs  to  the  promoter  of  the  enterprise 
and  which  any  other  promoter  would  easily  obtain. 

Promoters'  Legal  Status 

Legally  the  promoter  is  in  a  somewhat  anomalous  situ- 
ation inasmuch  as  he  is  acting  as  representative  of  an  enter- 
prise which  is,  perhaps,  not  yet  formed,  or  which,  even  if 
incorporated,  is  wholly  a  product  of  his  own.  The  pro- 
moter's actions  and  promises  cannot  legally  bind  the  corpora- 
tion, although  the  promoter,  ^s  an  individual,  may  be  called 
upon  to  see  to  it  that  arrangements  concluded  on  behalf  of 
the  corporation  are  actually  carried  out.  The  promoter, 
furthermore,  stands  in  a  limited  trust  relationship  to  the  cor- 
poration and  to  the  holders  of  securities  which  he  has  sold. 
This  trust  relationship  forbids  him  from  making  secret 
profits  at  the  expense  of  the  corporation.  He  may  make 
reasonable  open  profits  without  objection;  as  for  instance 
when  he  buys  a  given  property  which  is  essential  to  the 
corporation,  at  a  known  price,  and  transfers  it  to  the  corpora- 
tion at  a  known  higher  price.  But,  in  case  he  should  buy  this 
same  property  and  transfer  it  to  the  corporation,  making  a 


THE   PROMOTER  257 

profit  for  himself  without  making  known  this  profit,  then  he 
would  be  guilty  of  a  fraud  against  the  purchasers  of  the 
corporation's  securities. 

Among  innumerable  cases  that  might  be  cited  to  illustrate 
this  statement,  the  following  description  of  a  Florida  land  deal 
has  been  selected : 

In  April,  191 1,  five  persons  acting  jointly  as  promoters  of 
an  enterprise,  purchased  23,300  acres  of  land  at  $5.50  an  acre 
— a  total  consideration  of  $128,150.  On  this  contract  they 
paid  $5,000,  the  remainder  to  be  paid  at  the  rate  of  $2,500  per 
month.  They  then  caused  the  incorporation  of  the  ''Southern 
Land  Company"  for  $250,000,  and  entered  into  a  contract  with 
the  new  company  under  which  they  transferred  the  acreage 
above  mentioned  for  $8  per  acre.  By  further  agreement,  pay- 
ments were  made  by  the  new  corporation  direct  to  the  original 
vendor  of  the  land,  so  that  the  five  promoters  were  relieved  of 
all  further  trouble  and  responsibility.  Their  profits  were  to 
come  in  the  form  of  final  payments  to  them  after  the  payments 
to  the  original  vendor  had  been  completed.  Later,  legal  diffi- 
culties between  the  original  vendor  and  the  Southern  Land 
Company  arose,  which  made  necessary  the  giving  of  notes  by 
the  land  company  and  readjustment  of  their  relations.  There- 
upon the  five  promoters  came  forward  with  a  proposition  to 
the  land  company  that  they  would  transfer  to  the  land  com- 
pany their  contract  to  purchase  the  land  at  $5.50  per  acre.  In 
consideration  for  giving  up  the  difference  between  $5.50  and 
$8  per  acre,  they  would  accept  $30,000  full-paid  stock  in  the 
Southern  Land  Company.  Objection  was  made  to  the  trans- 
action on  the  ground  that  the  promoters  had  no  right  to  any 
profits  whatsoever,  inasmuch  as  they  were  acting,  when  they 
purchased  the  land,  in  a  trust  relationship  to  the  corporation 
and  to  the  later  security  holders.  The  prospectus  of  the  South- 
ern Land  Company  stated  that  the  land  had  been  purchased 
at  $8  per  acre,  but  did  not  state  from  whom  it  had  been  pur- 


258  SECURING   CAPITAL 

chased  nor  what  profits  had  been  made  on  the  purchase  by  the 
promoters  of  the  corporation. 

On  the  above  statement  of  fact  it  seems  there  can  be  Httle 
question  but  that  the  promoters  gave  themselves  profits  to 
v^hich  they  v^ere  not  entitled.  If  the  corporation  had  first 
been  formed  and  an  independent  board  of  directors  had  been 
elected  so  that  the  promoters  would  then  have  had  to  deal  with 
this  board,  it  is  probable  that  no  legal  question  could  have  been 
raised  as  to  any  profits  they  might  make.  But  in  this  instance 
they  were  dealing  with  a  corporation  which  was  completely  in 
their  own  hands,  and  they  appear  clearly  to  have  abused  this 
relationship. 

Promotion  Risks 

At  the  beginning  of  this  chapter  the  case  was  mentioned 
of  Seymour  Scott  who,  having  carried  through  two  successful 
promotions,  lost  everything  that  he  had  made  on  both  of  them 
in  an  unsuccessful  beet  sugar  promotion.  Mr.  Scott's  experi- 
ence is  not  abnormal;  on  the  contrary,  the  probabilities  are 
that  loss  and  failure  in  promotion  is  the  ultimate  result  of 
fully  one-half  of  the  serious  attempts  to  start  new  enterprises. 

There  are,  to  be  sure,  classes  of  enterprise  in  which  failure 
has  become  rare,  as  for  example  public  utility  corporations. 
The  standards  for  estimating  the  probable  income  and  ex- 
penses of  such  corporations  have  become  so  exact,  and  the 
estimating  is  now  so  carefully  and  scientifically  done,  that 
there  is  little  reason  to  fear  disaster.  The  chief  risks  in  these 
enterprises  are,  first,  the  possibility  of  onerous  regulation  or 
partial  confiscation  of  profits  by  governmental  authorities; 
second,  the  possibility  that  the  territory  which  they  serve  may 
decline  in  population  and  wealth. 

Other  enterprises,  particularly  those  engaged  in  manufac- 
turing and  trading,  are  most  apt  to  be  shipwrecked  through 
lack  of  careful  calculation,  foresight,  and  provisions  for  the 


THE   PROMOTER 


259 


future.  Yet,  in  addition  to  these  probable  causes  of  disaster, 
there  are  innumerable  contingencies  which  cannot  be  foreseen. 
This  is  true  of  all  business  enterprises.  In  addition  to  the  seri- 
ous risk  that  the  new  enterprise  itself  may  prove  to  be  unsuc- 
cessful and  all  the  promoter's  profits,  represented  in  common 
stock,  may  be  wiped  out,  there  is  the  further  risk  to  the  pro- 
moter that  he  may  fail  to  carry  through  the  enterprise  and 
may  lose  all  his  own  expenditures  of  money,  time,  and  energy 
devoted  to  its  promotion.  This  may  easily  occur  without  any 
fault  traceable  to  the  promoter.  The  writer  has  in  mind  one 
instance  in  which  a  year's  work,  some  tens  of  thousands  of 
dollars  of  expenses  and  additional  tens  of  thousands  of  dollars 
interested  in  options  were  lost  to  the  promoter  through  the 
sudden  death  of  one  of  the  principals  in  a  small  combination 
which  he  was  organizing. 

Besides  the  monetary  loss,  there  is  constantly  a  serious  risk 
in  promotion,  even  of  the  most  legitimate  kind,  of  damage  to 
the  promoter's  business  reputation.  In  order  to  attract  capital 
he  makes  many  recommendations,  which  he  may  believe  to  be 
thoroughly  justified.  If  the  enterprise  is  successful,  the  for- 
tunate purchaser  of  stock  thanks  his  own  excellent  business 
judgment  and  forgets  that  he  was  persuaded  to  accept  the 
judgment  of  the  promoter;  if  the  enterprise  is  a  failure,  these 
same  representations  are  likely  to  be  used  as  material  for  legal 
and  personal  attack.  After  the  disastrous  failure  of  the  United 
States  Shipbuilding  Company,  there  was  a  great  deal  of  dis- 
cussion as  to  whether  the  real  promoter  was  Colonel  John  J. 
McCook,  a  New  York  lawyer,  or  John  W.  Young,  a  New 
York  banker.  Colonel  McCook  was  said  to  have  employed 
auditors  who  investigated  the  value  and  earnings  of  the  plants 
to  be  absorbed,  and  was  also  said  to  have  introduced  two  of 
the  principals  in  the  new  combination  to  each  other.  On  the 
other  hand,  Mr.  Young  represented  to  certain  of  the  vendors 
that  he  had  employed  the  auditors ;  and  he  was  the  only  person 


26o  SECURING   CAPITAL 

who  apparently  possessed  their  detailed  statement.  It  was 
claimed  further  that  Mr.  Young  was  the  man  who  actually 
introduced  the  two  principals  just  referred  to.  Dewing  ex- 
pressed the  opinion  ''that  Mr.  Young  was  the  promoter  and 
that  Colonel  McCook  actively  co-operated  with  him  in  floating 
the  plan,  but  could  not  be  considered  responsible  for  certain 
misrepresentations."* 

The  instance  serves  as  a  clear  illustration  of  the  point  that 
an  unsuccessful  promotion  necessarily  carries  with  it  some 
discredit  to  all  who  are  connected  with  it,  and  particularly 
to  the  organizers  of  the  enterprise. 

Promoters*  Profits 

Earlier  in  the  chapter  some  indication  has  been  given  of  the 
customary  method  by  which  the  promoter  acquires  his  profits. 
The  fundamental  principle  is  that  he  is  entitled  to  whatever 
remains  of  the  capitalized  value  of  the  enterprise  after  the 
capital  which  it  requires  has  been  obtained.  To  make  the 
practice  entirely  clear,  let  us  take  a  simple  hypothetical  case. 
A  promoter  determines  that  a  given  manufacturing  enter- 
prise will  ordinarily  earn,  after  it  has  completed  a  two-year 
period  of  development,  in  excess  of  $100,000  per  annum  net 
profits.  If  he  is  conservative,  he  will  perhaps  figure  on  creat- 
ing securities  all  of  which  will  be  salable  at  par  on  the  fol- 
lowing basis: 

$500,000  6%  first  mortgage  bonds $30,000 

$250,000  8%  preferred  stock 20,000 

$500,000  common  stock  yielding  10%   50,000 

Total  capitalization $100,000 

We  will  assume  that  the  corporation  actually  needs 
$1,000,000  cash,  and  that  the  expense  of  investigation,  secur- 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  p.  472. 


THE    PROMOTER  261 

ing  options,  incorporation,  and  selling  securities  amounts  in 
total  to  $150,000.  Under  these  conditions,  the  promoter 
would  probably  enter  a  contract  to  turn  over  $1,000,000  in 
cash,  or  possibly  property  and  total  assets  for  which  he 
would  actually  pay  $1,000,000,  in  exchange  for  all  the  bonds, 
preferred  stock,  and  common  stock  of  the  corporation.  He 
would  then  be  able  to  sell  bonds,  preferred  stock,  and  $250,000 
of  the  common  stock,  and  would  retain  for  himself  $250,000, 
against  which  should  be  offset  his  expenses  of  $150,000.  In 
other  words,  under  all  these  estimates,  his  net  profits  would 
be  $100,000,  which  would  presumably  be  realized  in  common 
stock. 

Naturally  the  situation  is  not  quite  so  simple  in  practice ; 
nevertheless,  the  same  principle  can  be  readily  applied  of 
capitalizing  prospective  income  and  selling  or  exchanging  all 
of  the  securities  necessary  in  order  to  put  the  corporation 
on  its  feet,  the  remainder  of  the  securities  being  left  as  the 
profits  of  promotion.  There  is,  however,  another  complica- 
tion to  be  considered  here,  namely,  the  fact  that  a  promoter 
very  seldom  works  completely  alone.  It  would,  in  all  proba- 
bility, prove  essential  for  him  to  secure  the  co-operation  of 
certain  bankers  and  of  men  who  have  some  special  knowl- 
edge or  prestige,  and  he  will  be  compelled  to  divide  his  profits 
with  them.  Quite  frequently  the  original  promoter  builds 
up  a  more  of  less  formal  promoters'  syndicate,  of  which  he 
is  manager,  and  which  shares  in  whatever  gain  he  makes. 

The  principle  that  the  promoter  will  accept  as  his  com- 
pensation a  portion  of  the  final  equity  in  the  corporation  is 
well  established.  Otherwise — in  case,  for  instance,  he  insists 
upon  receiving  bonds  or  preferred  stock — he  reveals  a  lack 
of  faith  on  his  part  in  the  success  of  the  enterprise  that 
would  probably  be  fatal  to  his  whole  promotion  scheme. 
This  principle  is  applied  in  the  United  States  freely,  leav- 
ing to  the  promoter  a  block  of  the  common  stock.     In  Eng- 


262  SECURING   CAPITAL 

lish  practice  another  arrangement,  which  is  in  some  respects 
preferable,  has  been  common.  In  addition  to  bonds,  prefer- 
ence shares,  and  ordinary  shares,  the  organizers  of  a  new 
corporation  frequently  cause  to  be  created  a  final  claim  on 
the  property,  ranking  after  ordinary  or  common  shares,  this 
final  claim  being  represented  by  "founders'  "  shares.  The 
founders*  shares  ordinarily  are  entitled  to  dividends  only 
after  certain  dividends  have  been  paid  on  ordinary  shares, 
after  which  they  are  entitled  to  participation  in  additional 
dividends.  A  favorite  arrangement  is  to  give  the  ordinary 
shares,  say,  6%  as  their  preference  above  founders'  shares, 
and  then  to  divide  additional  profits  equally  between  ordinary 
shares  and  founders'  shares.  The  founders'  shares  are  usu- 
ally issued  to  a  small  nominal  amount  with  a  small  par 
value  to  each  share,  often  only  one  shilling.  In  a  few  in- 
stances where  the  companies  have  been  phenomenally  suc- 
cessful, the  founders'  shares  have  become  extremely  valuable, 
and  there  are  even  cases  in  which  separate  corporations  have 
been  formed  in  order  to  hold  the  total  block  of  founders' 
shares  and  to  sell  interests  in  this  block.  The  advantage  of 
this  English  practice  is  that  it  defers  promoters'  profits  until 
after  those  who  have  contributed  cash  have  been  fully 
protected. 

Illustrative  Instances 

We  may  select  from  Dewing  a  few  instances  in  corporate 
practice  which  will  show  just  how  promoters  have  secured 
their  profits. 

In  the  case  af  the  Mount  Vernon- Woodberry  Cotton  Duck 
Company,  the  promoters  had  remaining  in  their  hands 
$6,250,000  in  common  stock.  Figuring  its  market  value  at 
$25,  this  amounted  to  a  cash  profit  of  well  over  $1,500,000. 
However,  Mr.  Parks,  the  chief  promoter,  was  in  no  situation 
to  keep  all  these  profits  for  himself;  they  were  divided  to  a 


THE   PROMOTER 


263 


great  extent  among  the  various  mill-owners  whose  personal 
co-operation  had  been  necessary. 

The  United  States  Realty  and  Construction  Company  was 
incorporated  in  1902  with  a  capitalization  of  $30,000,000 
preferred  and  $36,000,000  common  stock.  The  five  pro- 
moters, who  included  some  well-known  and  highly  respected 
citizens  of  New  York,  stated  publicly  that  they  would  receive 
a  profit  for  organizing  the  new  corporation  and  for  procuring 
the  necessary  working  capital.  The  announcement  was  put  in 
the  following  form : 

It  is  proper  to  state  that  we  expect  to  receive  for  the 
responsibility  and  risks  assumed  by  us  in  organizing  the 
new  corporation,  procuring  the  cash  capital,  and  for  the 
expenses  incurred,  an  individual  profit  which  will  or  may 
include  the  stock  of  the  new  corporation  remaining  in 
our  hands  after  carrying  through  the  transaction. 

The  promoters'  profits  in  this  case  are  calculated  to  have 
amounted  to  about  $6,000,000  in  common  stock,  or  approxi- 
mately 10%  of  the  total  securities.  At  the  outset  the  market 
value  was  about  $1,800,000,  and  it  had  an  average  value  dur- 
ing the  first  year  of  $720,000. 

In  the  promotion  of  the  Glucose  Sugar  Refining  Company, 
in  1897,  a  promoting  syndicate  was  formed  which  received 
$100  in  preferred  stock  and  $142.85  in  common  stock,  for 
every  $100  subscribed  in  money.  In  accordance  with  these 
terms,  the  subscribers  paid  in  $4,500,000  cash,  and  received 
$4,500,000  in  preferred  and  $6,428,250  of  common  stock.  In 
addition,  the  promoters  got  approximately  $3,000,000  in  com- 
mon stock  for  special  funds,  purchase  money,  bonuses,  law- 
yers' expenses,  and  the  like.  The  promoter,  Joseph  B.  Green- 
hut,  received  direct  a  fee  of  $500,000  in  common  stock.  Using 
the  average  quotation  immediately  after  the  formation  of  the 
combination,  and  omitting  indirect  profits,  the  promoters  and 


264  SECURING    CAPITAL 

underwriting  syndicate  appear  to  have  obtained  an  immediate 
profit  of  $4,500,000. 

At  the  organization  of  the  American  Bicycle  Company,  in 
1898,  the  issues  constituted  $9,300,000  preferred,  $17,700,000 
common,  and  $10,000,000  debenture  bonds.  For  the  constitu- 
ent plants  the  promoter  paid  approximately  $6,700,000  in  pre- 
ferred stock,  $11,000,000  in  common,  and  $7,230,000  in  deben- 
ture bonds,  leaving  himself  approximately  $2,600,000  in  pre- 
ferred, $6,700,000  in  common,  and  $1,800,000  debentures. 
In  spite  of  these  enormous  paper  profits,  Dewing  says  that 
after  the  promoter  had  paid  the  charges  and  commissions  of 
bankers,  attorneys,  and  others,  there  remained  only  a  small 
profit  for  himself. 

At  the  formation  of  the  American  Malting  Company,  in 
1897,  the  amount  left  over  for  the  promoters  after  the  22 
plants  of  the  company  had  been  purchased,  and  over  $2,000,000 
of  cash  working  capital  provided,  amounted  to  $500,000  of 
preferred  stock  and  $7,750,000  common  stock.  This  was  out 
of  a  total  of  $12,500,000  preferred  and  $13,750,000  common. 

From  all  of  the  above  instances,  it  is  clear  that  successful 
promotion  may  carry  with  it  very  large  profits,  and  yet  we 
must  not  overlook  expenses  and  risk  which  seem,  on  the 
whole,  to  make  these  profits  reasonable.  After  a  careful  study 
of  various  promotions.  Dewing  comes  to  the  conclusion  that 
"the  extravagant  feature  of  a  promotion  is  usually  connected 
with  the  indirect  rather  than  the  direct  profit."  The  pro- 
moter, after  all,  is  probably  entitled  to  what  he  gets. 


CHAPTER    XII 

PROMOTING     COMBINATIONS 

Development  of  Industrial  Combinations 

Among  the  fields  for  promotive  activities  probably  the  one 
that  has  attracted  the  most  public  attention  is  the  formation  of 
combinations  of  previously  existing  companies.  Most  concerns 
are  developed  at  the  outset  as  isolated  enterprises.  At  a  later 
stage,  however,  nearly  every  expanding  company  comes  into 
closer  and  closer  relations  with  the  concerns  from  which  it 
buys  and  sells,  and  may  even  establish  some  financial  con- 
nections with  them.  It  is  likely,  also,  to  come  into  increas- 
ingly bitter  competition  with  rival  concerns,  which  competi- 
tion may  either  seriously  cut  its  profits  or  may  greatly  limit 
the  field  of  its  operations.  Thus,  there  exists  an  almost  uni- 
versal tendency  toward  combination  along  one  or  both  of  the 
following  lines : 

1.  The  first  type  may  be  called  "vertical  combination," 

which  means  the  establishment  of  joint  control  over 
two  or  more  concerns  that  are  buying  and  selling 
from  each  other. 

2.  The  second  type  may  be  referred  to  as  "horizontal 

combination,"  which  means  the  establishment  of 
joint  control  over  two  or  more  competitive  con- 

I.  cerns. 

Vertical  combination  is  especially  common  between  pur- 
asers  of  raw  materials,  which  may  be  wholly  or  partially 
monopolized,  and  the  manufacturers  of  these  materials.  It  is 
also  common,  on  the  other  hand,  between  manufacturers  who 
do  not  sell  direct  to  the  final  consumers  of  their  products  and 

265 


266  SECURING   CAPITAL 

some  of  the  middlemen  who  intervene.  The  United  States 
Steel  Corporation  is  a  notable  example  of  a  complete  vertical 
combination,  since  it  includes  great  iron-mining  companies, 
ships  and  railroads  for  the  transfer  of  ore,  blast  furnaces, 
manufactories  of  finished  iron  and  steel  products,  and  selling 
agencies,  notably  the  United  States  Steel  Products  Company, 
which  handles  all  the  export  selling.  Here  is  a  complete  in- 
tegrated organization  which  carries  on  the  whole  process  of 
mining,  manufacturing,  and  selling.  The  United  States  Steel 
Corporation  in  some  of  its  aspects  also  is  a  horizontal  combi-  i 
nation.  Examples  of  combinations  between  competing  con- 
cerns are  not  difficult  to  find,  and  will  readily  occur  to  every 
reader. 

Naturally,  the  large  combinations,  with  their  hundreds  of 
millions  of  dollars  of  capital,  have  attracted  most  attention. 
It  is  not  always  realized  that  the  combination  movement  is 
going  on  also  among  comparatively  small  concerns,  and  that 
the  aggregate  importance  of  smaller  combinations  is  probably 
even  greater  than  the  aggregate  importance  of  the  huge  com- 
binations that  have  their  securities  listed  on  the  stock  ex- 
changes. The  idea  of  taking  over  an  interest  in  another  con- 
cern, or  the  idea  of  forming  a  new  corporation  which  shall 
hold  control  of  two  or  more  other  concerns,  is  now  entirely 
familiar  and  is  being  applied  in  hundreds  of  cases.  In  a  great 
many  of  the  smaller  cities,  manufacturers  who  have  been  op- 
erating on  a  comparatively  small  scale  have  in  recent  years 
combined  their  facilities.  The  remarkable  growth  of  business 
associations  made  up  of  competitive  manufacturers  or  traders 
has  been  a  factor  of  importance  in  facilitating  this  movement 
toward  small  combinations. 

If  the  combination  is  purely  a  case  of  one  concern  purchas- 
ing a  controlling  interest  in  one  or  more  other  concerns,  there 
is  no  distinct  process  of  promotion.  In  cases,  however,  where 
a  new  corporation  is  formed  to  take  over  two  or  more  previ- 


PROMOTING   COMBINATIONS  267 

ously  independent  corporations,  promotion  is  an  essential  fea- 
ture of  the  arrangement.  Some  person,  or  group  of  persons, 
must  conceive  the  combination,  must  carry  on  investigations, 
work  out  a  financial  plan,  assemble  their  proposition,  see  to 
its  preliminary  financing,  and  finally  dispose  of  the  securities 
put  out  by  the  new  corporation.  The  process  of  promoting  a 
combination  differs  in  many  particulars  from  the  promotion  of 
a  single  enterprise,  and  in  view  of  its  importance  is  worth  some 
separate  study. 

Fields  for  Combinations 

We  have  spoken  above  chiefly  of  combinations  among 
manufacturing  concerns;  and  this  is  probably  the  field  in 
which  the  tendency  has  in  recent  years  been  strongest.  How- 
ever, it  should  not  be  forgotten  that  there  are  other  fields 
for  combination.  Among  the  trading  companies  there  have 
been  a  great  many  mergers  or  alliances  of  department  stores 
and  of  groups  or  ''chains"  of  small  retail  stores.  Some- 
times these  chains  of  stores  have  grown  up  in  a  very  loose 
association,  held  together  really  by  the  personality  of  one  or 
two  men  who  are  interested  in  each  of  the  separate  stores 
or  plants.  This  loose  association,  it  may  be  remarked,  is 
especially  common  in  the  trade  publication  field,  where  one 
man  will  often  possess  a  controlling  .interest  in  a  number  of 
trade  papers,  each  one  of  which  has  its  own  separate  cor- 
poration and  organization. 

An  example  of  a  similar  arrangement  in  the  retail  store 
field  is  the  so-called  Besse  System  Stores  in  New  England, 
all  of  which  are  directed  by  L.  W.  Besse.  There  is  a  dif- 
ferent partner  in  each  store.  The  management  has  already 
announced  that  this  arrangement  is  not  sufficiently  stable  and 
does  not  admit  of  scientific  methods  of  administration;  and 
presumably  it  will  be  replaced  sooner  or  later  by  a  single 
corporation  which  will  be  a  combination  of  all  the  Besse 


268  SECURING  CAPITAL 

stores.  This  is  the  manner  in  which  loose  associations  of 
business  interests  usually  develop  into  formal  combinations. 
Much  the  same  process  has  been  gone  through  by  the  F.  W. 
Woolworth  Company  and  the  Knox  Company,  both  being 
owners  of  systems  of  chain  stores. 

The  movement  toward  combination  has  recently  been 
strong  among  companies  in  the  moving  picture  field.  In 
1913-1914,  three  film  companies,  with  an  aggregate  capital  of 
$1,500,000,  were  floated  by  a  stock  exchange  house.  At 
about  the  same  time  there  was  a  $5,000,000  merger  of  three 
film-producing  companies.  In  the  early  part  of  19 14,  a 
$25,000,000  amalgamation  was  being  talked  of. 

Combinations  among  banks  are  also  not  uncommon ;  the 
great  Continental-Commercial  National  Bank  of  Chicago 
being  a  noteworthy  example.  This  tendency  has  been  particu- 
larly prominent  in  English  finance  for  the  last  twenty-five  or 
thirty  years.  According  to  Huth  Jackson,  the  number  of 
individual  banks  in  England  and  Wales  declined  from  366 
in  1887,  to  133  in  1913;  209  banks  disappearing  through  pur- 
chase or  amalgamation.  The  tendency  is  successful  because 
it  produces  stronger  banks  with  a  more  diversified  clientele, 
which  are  less  likely  to  be  swamped  by  local  disturbances. 

Another  field  in  which  there  has  been  a  great  deal  of 
combination  is  among  public  utilities — including  gas  and  elec- 
tric light  and  power  companies,  street  railways,  water  works, 
irrigation  works,  and  the  like.  Combinations  in  the  public 
utility  field  are  of  a  slightly  different  type  from  those  in  the 
manufacturing  field.  Usually  they  include  a  considerable 
number  of  local  companies,  each  one  operating  in  its  own 
community,  which  communities  may  be  far  distant  from  one 
another.  In  fact,  it  is  regarded  as  a  point  of  strength  if  the 
various  companies  in  a  public  utility  combination  are  not 
affected  by  the  same  geographical  or  economic  conditions, 
thus  minimizing  the  danger  that  all  of  them  may  be  seriously 


PROMOTING   COMBINATIONS  269 

depressed  at  the  same  time.  While  a  combination  of  this 
type  may  be  classed  as  "horizontal,"  it  is  evidently  made  up, 
not  of  competing  enterprises,  but  of  enterprises  which  may 
profitably  co-operate  in  such  activities  as  the  purchase  of  raw 
materials,  securing  high-grade  engineering  talent,  comparing 
experiences,  and  the  like.  The  great  advantage,  however, 
which  the  public  utility  combination  has  to  offer  is  the  fact 
that  it  can  float  bond  and  stock  issues  on  a  large  scale  and 
give  them  a  national  market,  whereas  the  local  public  utility 
company  experiences  difficulty  in  selling  its  securities  outside 
its  local  market.  As  a  result,  "about  78.5%  of  the  total  gas, 
electric  light,  and  traction  capital  of  operating  public  utilities 
is  now  owned  by  holding  companies.  The  average  electric 
light  company  has  about  $342,000  of  securities  outstanding. 
The  undertaking  is  too  small  to  finance  itself  efficiently  when 
it  has  to  increase  its  capital  investment  about  20%  per  annum ; 
that  is  why  the  holding  company  is  efficient  as  a  financial 
medium."* 

Difficulties  in  Forming  a  Combination 

Under  the  most  favorable  circumstances,  the  promoter 
does  not  lead  an  easy  life.  In  investigating  whatever  prop- 
osition he  has  in  mind,  he  must  expend  both  money  and  time 
freely  and  it  is  quite  likely  that  his  efforts  will  be  fruitless; 
he  must  exercise  diplomacy  and  patience  in  securing  his 
options  or  otherwise  assembling  his  proposition ;  he  must  pro- 
tect himself  with  the  greatest  care  and  forethought  if  he  is 
to  reap  the  reward  of  his  efforts ;  he  must  approach  the  owners 
of  capital  with  a  proposition  which  he  believes  to  be  favorable 
to  them,  and  yet  must  be  prepared  for  rebuffs  and  suspicion. 
These  are  the  customary  difficulties  in  promoting  any  enter- 
prise. 

The  above  difficulties  are  doubled  or  tripled  when  the 

♦Article  by  W.  H.  Gardiner  in  New  York  AnnoMst,  June,  1915. 


270 


SECURING   CAPITAL 


enterprise  is  a  combination  of  previously  independent  con- 
cerns. And,  if  the  combination  includes  concerns  that  have 
been  previously  competitive,  the  promoter  is,  first  of  all,  con^ 
fronted  with  the  necessity  of  conciliating  individuals  who 
perhaps  for  years  have  been  fighting  each  other  with  all  the 
weapons  at  their  command.  Furthermore,  the  business  in- 
terests of  each  separate  concern  going  into  the  combination 
demand  that  it  should  make  for  itself  the  largest  claims  that 
it  can  reasonably  support  and  should  look  with  much  sus- 
picion on  the  claims  that  are  advanced  by  the  other  con- 
cerns. Unless  the  promoter  is  a  man  of  much  force  and 
unusual  tact,  it  is  almost  inevitable  that  the  negotiations 
should  break  off  as  a  result  of  mutual  distrust.  This  has 
been  the  result  again  and  again,  even  though  every  person 
interested  may  have  fully  recognized  the  desirability  of  the 
proposed  combination  for  the  common  good  of  all. 

In  addition  to  the  questions  and  conflicts  that  arise  in  deter- 
mining the  financial  terms  of  the  combination,  the  creation  of 
a  working  organization  for  the  combination  is  more  than  likely 
to  break  up  all  negotiations.  If  the  promoter  is  a  true  diplo- 
mat, he  will  probably  try  to  postpone  consideration  of  the 
management's  personnel  until  after  previous  questions  have 
all  been  disposed  of.  Nevertheless,  it  may,  at  the  last  mo- 
ment wreck  the  whole  project.  The  promoter  must  usually 
make  up  his  mind  between  one  of  two  courses :  either  he  must 
bring  in  an  outsider  of  high  standing  as  the  chief  officer  of  the 
combination  and  give  him  discretion  to  pick  the  best  men  he 
can  find,  thus  creating  an  efficient  working  organization,  or 
he  must  "play  politics"  and  choose  the  officers  from  the  men 
whose  influence  he  requires  in  order  to  form  the  combination. 
If  he  chooses  the  first  alternative,  he  must  make  his  appeal 
most  strongly  to  the  men  who  have  capital  invested  and  whose 
business  sense  will  lead  them  to  respect  the  necessity  and  jus- 
tice of  the  proposed  course  of  action,  even  though  it  may 


PROMOTING   COMBINATIONS 


271 


involve  sacrifices  on  the  part  of  some  individuals.  If  he 
chooses  the  second  alternative,  he  must  make  his  appeal  pri- 
marily to  the  active  officers  of  the  concerns  that  are  to  be  com- 
bined, and  must  depend  upon  them  to  help  him  in  influencing 
the  owners  of  capital.  Unfortunately,  this  second  alternative 
is  too  often  chosen,  and  is  probably  the  direct  cause  of  the 
breakdown  of  various  combinations  which  should  'have  proved 
highly  successful. 

The  writer  has  in  mind  one  combination  formed  within  the 
last  five  years,  which  is  still  running  and  on  the  surface  appears 
to  be  prosperous.  The  officers,  however,  were  all  chosen 
because  of  their  influence,  not  because  of  their  abilities.  The 
president  was  formerly  the  head  of  a  small  and  efficient  plant 
which  v/as  much  needed  in  the  combination.  He  is  a  good 
manager  of  a  one-man  plant,  but  is  wholly  without  training  or 
ability  to  control  a  large  organization.  The  treasurer  was  the 
head  of  one  of  the  larger  companies  absorbed  in  the  combina- 
tion; he  draws  a  larger  salary  than  the  president,  yet  has 
almost  no  active  duties  and  devotes  most  of  his  time  to  other 
business  enterprises.  The  vice-president  is  a  relative  of  one  of 
the  bankers  who  helped  to  finance  the  combination.  He  is 
supposed  to  be  one  of  the  operating  officials,  yet  he  and  the 
president  are  scarcely  on  speaking  terms  with  each  other.  The 
other  officers,  including  even  some  of  those  in  subordinate  posi- 
tions, were  similarly  chosen  for  political  reasons. 

It  seems  scarcely  possible  that  this  particular  combination 
snould  continue  to  exist  much  longer.  Yet  it  may  happen 
that  an  internal  reorganization  will  be  effected  before  it  is 
too  late,  and  thus  the  combination,  which  is  probably  basically 
sound,  will  after  all,  prove  to  be  the  success  that  was 
anticipated. 

The  difficulties  which  have  to  be  overcome  in  organizing 
a  combination  among  long-time  competitors  may  be  illus- 
trated  by   recording   the    facts   as   to   a   recent   attempt   to 


272 


SECURING   CAPITAL 


organize  a  combination  in  the  publishing  field,  as  told  by  one 
of  those  interested: 

An  outside  promoter  was  endeavoring  to  form  the 
combination,  but  he  was  hampered  by  the  fact  that  he 
is  well  known  in  the  publishing  field,  and  had  had  previ- 
ous business  dealings  with  the  owners  of  the  separate  . 
companies.  Most,  if  not  all,  of  the  men  whom  he 
approached  regarded  his  arguments — whether  justly  or 
not    is    beside    the    point — with    distrust. 

One  of  these  men  stated,  for  example,  that  the  pro- 
moter was  a  man  of  the  type  who,  having  himself  had 
several  disastrous  experiences,  had  decided  that  he  had 
become  an  expert  well  qualified  to  tell  more  successful 
publishers  how  to  conduct  their  business. 

Inasmuch  as  the  proposed  combination  looked  some- 
what attractive  to  all  of  the  men  approached,  the  pro- 
moter was  able  to  arrange  for  a  meeting  of  these  men 
in  his  office.  At  this  meeting,  which  was  informal,  the 
promoter  presided  and  undertook  to  draw  out  expres- 
sions of  opinion  from  each  person  present.  No  personal 
unfriendliness  was  manifest,  and  the  meeting  proceeded 
harmoniously  enough,  until  the  question  of  the  price  to 
be  paid  for  each  company  taken  into  the  combination 
was  raised.  At  this  point,  naturally,  it  was  difficult  to 
reach  any  agreement,  particularly  as  each  one  present 
was  more  anxious  to  draw  out  the  others  than  to 
present  his   own  ideas. 

If  the  promoter  had  commanded  a  great  deal  of  re- 
spect, or  even  if  he  had  been  an  outsider  who  was  believed 
to  be  capable  and  impartial,  he  would  have  been  able  to 
put  through  some  definite  plan  for  appraising  each  of 
the  companies  interested.  The  truth  was,  however, 
that  he  had  no  more  influence  than  any  of  the  other  per- 
sons present  and  his  plan  for  appointing  an  appraisal 
committee,  with  himself  as  chairman,  was  coldly  received. 
Inasmuch  as  no  better  plan  was  brought  forward,  the 
meeting  finally  adjourned  without  definite  result  and  the 
same  group  of  men  were  never  afterwards  brought  to- 
gether. 


PROMOTING   COMBINATIONS 


273 


Preliminary  Investigation 

Among  the  questions  that  should  be  fully  and  clearly 
answered  before  any  combination  of  going  concerns  is 
attempted,  are  the  following: 

1.  What  is  the  financial  history  of  each  concern  that  is 
to  be  considered  as  a  possible  member  of  the  combination? 
How  long  has  it  been  in  existence?  Is  its  organization  stable? 
Are  its  earnings  increasing  or  decreasing?  Are  adequate 
depreciation  and  other  reserves  deducted  before  estimating 
profits?    Is  the  plant  and  physical  property  in  good  condition? 

2.  Who  are  the  men  engaged  in  this  industry  who  have 
shown  the  most  enterprise  and  good  judgment?  Will  they 
join  in  the  proposed  combination  and  work  together  on  har- 
monious terms?  Will  it  be  necessary  to  give  positions  to 
incompetents  or  to  make  unfair  concessions  in  order  to  in- 
fluence men  who  are  essential  to  the  combination? 

3.  What,  if  any,  advantages  as  a  money  maker  will  the 
proposed  combination  have  over  the  separate,  independent 
concerns?  Will  the  combination  be  in  violation  of  any  laws? 
Will  it  be  necessary  to  raise  prices  or  otherwise  incur  any 
unpopularity  in  order  to  secure  larger  profits?  Is  it  possible 
to  introduce  more  efficient  methods  into  the  management  of 
the  various  plants  without  arousing  undue  hostility  at  the 
beginning? 

4.  Assuming  that  the  combination  is  agreed  to,  what 
should  be  the  financial  plan  of  the  proposed  combination? 
Upon  what  basis  can  its  securities  be  exchanged  for  the 
securities  of  the  independent  concerns?  On  what  basis  can 
other  securities  be  underwritten  and  sold  to  the  public?  How 
much  fresh  capital  will  the  combination  need?  Will  there 
remain  a  block  of  securities  sufficient  to  compensate  all  who 
took  part  in  the  promotion,  for  their  respective  risks  and 
expenditures? 

The  questions  above  suggested  are  by  no  means  exhaustive. 


274  SECURING   CAPITAL 

but  merely  indicate  the  lines  which  the  promoter  will  follow 
in  his  own  preliminary  investigation.  If  the  promoter  is  him- 
self engaged  in  the  industry  in  which  the  combination  is  to 
be  formed,  he  will  probably  be  familiar  at  first  hand  with 
the  answers  to  most  of  the  questions  listed  above.  Neverthe- 
less it  is  unsafe  for  him  to  depend  altogether  on  his  personal 
knowledge,  which  will  probably  be  inexact.  The  promoter 
must  in  any  case  proceed  with  much  discretion  and  even  with 
secrecy  in  gathering  the  preliminary  information  that  he 
needs ;  otherwise,  he  is  likely  either  to  arouse  suspicion,  which 
would  interfere  with  his  later  plans,  or  to  stir  up  premature 
discussion  and  arguments  that  might  lead  to  personal  dif- 
ferences or  might  even  favor  the  promotion  of  rival  plans. 

After  the  promoter,  or  his  immediate  associates  if  there 
is  a  group  of  promoters,  have  gathered  all  the  preliminary 
information  available,  it  will  be  possible  to  form  a  tentative 
plan  indicating  about  what  capitalization  the  proposed  com- 
pany should  possess,  and  what  terms  should  be  offered  to 
all  the  concerns  that  are  to  be  included.  It  is  usually  safe  to 
assume  that  this  tentative  plan  will  be  greatly  modified 
during  the  progress  of  negotiations. 

The  next  step,  usually,  is  to  meet  each  of  the  parties  whom 
he  hopes  to  interest,  in  a  separate,  personal  conference,  go 
over  the  whole  proposition,  and,  if  possible,  bring  each  con- 
cern into  line  to  the  extent  of  expressing  interest  and 
willingness  to  agree  to  some  recent  reasonable  basis  of  com- 
bination. Usually  it  would  not  be  considered  necessary  or  desir- 
able to  attempt  to  close  definite  contracts  by  this  process  of 
holding  conferences  with  the  separate  interests.  The  final 
agreement  should  result  after  a  general  conference  where  the 
united  views  of  all  the  participants  in  the  combination  will 
be  expressed. 

However,  it  has  already  been  pointed  out  that  in  the. 
case  of  the  Mount  Vernon-Woodberry  Company  the  pro- 


PROMOTING   COMBINATIONS  275 

moters  proceeded  to  purchase  outright  a  considerable  num- 
ber of  separate  plants,  and  then  went  ahead  with  their  finan- 
cial plans  and  their  sale  of  securities  to  the  public  on  their  own 
terms.  In  other  instances,  options  have  been  secured  or 
definite  contracts  have  been  closed  with  the  large  indepen- 
dent stockholders  in  the  constituent  companies  for  the  ex- 
change of  securities.  All  these  methods  of  promotion  have 
been  utilized  at  .one  time  or  another  in  order  to  obtain 
a  complete  mastery  of  the  situation,  so  that  no  meeting  of 
the  various  parties  interested  and  no  general  agreement  as  to 
a  basis  of  combination  will  be  called  for. 

In  the  usual  and  typical  case,  however,  the  next  step  after 
the  promoter  has  assured  himself  of  the  favorable  reception 
of  the  general  plan,  is  to  bring  together  the  important  repre- 
sentatives of  interests  that  are  to  be  included  in  the  combina- 
tion, in  an  endeavor  to  reach  an  agreement  regarding  a  basis 
of  combination. 

Basis  of  Combination* 

In  the  promotion  of  the  United  States  Leather  Company, 
in  1893,  the  initiative  was  taken  by  certain  manufacturers  who 
mutually  agreed  upon  the  necessity  of  forming  a  combination 
and  who  carried  through  the  whole  project  with  very  little 
outside  advice  or  assistance,  even  on  the  part  of  bankers. 
After  securing  the  agreement  of  the  principal  concerns  in  the 
leather  industry  to  the  general  principle  that  a  combination 
was  desirable,  the  leaders  of  the  movement  proceeded  to 
appoint  committees  for  the  purpose  of  appraising  the  physical 
properties  of  the  independent  concerns.  It  was  agreed  that 
the  new  company  should  issue  $100  in  preferred  stock  and 
$100  in  common  stock,  in  return  for  each  $100  of  the 
appraised  value  of  the  physical  properties.     In  this  way  the 

*The  statements  in  this  section  as  to  the  leather  and  starch  combinations  are 
based  upon  the  exceptionally  able  and  graphic  accounts  contained  in  Dewing's  "Cor- 
porate  Promotions   and   Reorganizations." 


276  SECURING   CAPITAL 

new  corporation  acquired  approximately  no  tanneries  con- 
trolled by  60  different  leather  houses,  about  400,000  acres  of 
bark  land,  and  bark  rights  on  100,000  acres  additional.  This 
was  a  very  simple  basis  of  combination.  The  plan  gave  no  con- 
sideration whatever  to  good-will,  patents,  contracts,  and  other 
intangible  assets — or  rather  the  plan  assumed  that  these 
intangible  assets  were  uniformly  equivalent  to  the  value  of 
the  tangible  assets.  On  this  basis,  the  new  corporation 
acquired  all  the  physical  properties  that  it  needed. 
^  The  next  problem  was  to  raise  working  capital,  which  was 
secured  through  an  issue  of  $10,000,000  debenture  bonds,  of 
which  $6,000,000  were  underwritten  and  issued  at  par.  The 
underwriting  syndicate  in  this  case  received  $600,000  par 
value  of  common  stock  as  a  10%  commission  for  underwrit- 
ing. It  is,  of  course,  to  be  borne  in  mind  that  the  common 
stock  did  not  have  a  market  value  even  approaching  par,  so 
that  the  actual  underwriting  commission  was  far  below  10%. 

The  later  history  of  the  leather  combination  was  unfor- 
tunate, but  this  need  not  concern  us  here.  The  manner  in 
which  the  combination  was  carried  through  and  the  agreed 
basis  of  combination  seem,  on  the  whole,  to  have  been  fair. 
The  tanners  who  joined  the  combination  considered  the  ap- 
praisals of  their  property  just;  outside  tanners,  however,  criti- 
cized the  appraisals  on  which  stock  was  issued  as  being  in  all 
cases  considerably  inflated. 

The  first  consolidation  in  the  starch  industry  was  the 
National  Starch  Manufacturing  Company  in  1890.  In  this 
case  the  promoter,  after  making  his  preliminary  investigation 
and  forming  his  financial  plan,  secured  options  on  twenty 
starch  manufacturing  plants.  All  the  options  stipulated  that 
the  vendors  should  receive  25%  of  the  value  of  their  mills  in 
cash;  33^%.  in  bonds;  2.2^2%  in  first  preferred  stock;  and 
i8j4%  in  second  preferred  stock.  In  addition,  each  manu- 
facturer was  to  receive  a  common  stock  bonus  of  27^^%. 


PROMOTING   COMBINATIONS  277 

The  working  capital  of  each  independent  concern  was  taken 
over  and  paid  for  in  cash. 

It  was  part  of  this  general  plan  that  the  promoter  himself, 
through  a  company  of  which  he  was  president,  should  furnish 
$1,545,750  cash,  for  which  he  received  an  equal  amount  in 
bonds  and  preferred  stock  and  100%  bonus  of  common  stock. 
Assuming  that  the  promoter  was  able  to  market  these  securi- 
ties at  the  prices  prevailing  during  the  first  two  years  follow- 
ing the  promotion,  his  compensation  amounted  to  $722,677. 

It  is  evident  that  in  this  instance,  although  the  promoter 
was  acting  on  his  own  responsibility,  there  was  a  common 
basis  of  valuation  and  terms  of  payment  for  the  plants  which 
were  turned  into  the  combination.  When  securities  are  ex- 
changed it  is,  in  fact,  necessary  that  there  should  be  some 
such  common  agreement — or  at  least  an  informal  understand- 
ing— for  otherwise  there  is  no  method  of  judging  the  probable 
value  of  the  securities  received  in  payment  for  the  plants. 

In  1889  another  promoter  planned  to  organize  a  second 
starch  combination,  and  a  meeting  was  held  in  the  office  of 
Charles  R.  Flint  of  New  York  for  the  purpose  of  deciding 
upon  the  basis  of  combination.  The  minutes  of  this  meeting 
have  been  preserved,  and  are  extremely  interesting  as  showing 
the  first  stages  in  the  process  of  organizing  a  combination. 

Memorandum  of  Meeting  held  in  the  office  of  Charles 
R.  Flint,  June  30,  at  10  a.m. 

Present:  Messrs.  Flint,  Auerbach,  T.  P.  Kingsford, 
Higgins,  Dnryea,  Morton,  and  Allen. 

It  is  agreed  to  organize  the  United  States  Starch  Com- 
pany with  a  capital  of  $2,500,000  preferred  6%  cumulative 
stock  and  $3,500,000  common  stock.  And  that  the  former 
shall  be  held  in  trust  by  the  United  States  Mortgage  and 
Trust  Company,  and  issued  later  through  bankers  to  be 
provided  by  Mr.  Flint.  The  common  stock  shall  also  be 
held  in  trust  for  the  owners  for  such  a  time  as  they 
may  elect. 


278 


SECURING   CAPITAL 

It  is  agreed  and  understood  that  the  vendors  shall 
receive  $950,000  in  cash,  $1,550,000  preferred  stock,  and 
$3,000,000  in  common  stock,  for  their  plants  and  in- 
ventories, to  be  provided  for  as  follows: 

First,  a  loan  shall  be  made  by  the  United  States 
Mortgage  and  Trust  Company  for  $950,000  for  nine 
months,  same  to  be  paid  from  the  proceeds  of  the  sale 
of  an  equal  amount  of  preferred  stock  to  be  issued  at 
such  time  as  in  the  judgment  of  the  Directors  may  be 
proper.    The  proceeds  of  this  loan  to  be  used  as  follows: 

To  pay  Kingsford $400,000 

"      "     Morton   175,000 

"      "     Graves 350,000 

"     "    Duryea   25,000 


Total  $950,000 

Second,  in  addition  to  the  cash  paid  as  above,  pre- 
ferred stock  shall  be  assigned  to  the  vendors  as  follows: 

Kingsford  . . .  .$1,100,000  on  plant  and  inventory 

Morton  125,000  "    plant 

Duryea   100,000  "    inventory 

"        75,000  "    plant 

Graves    100,000  "    inventory 

"        50,000  "   plant 


Total $1,550,000 

which  shall  be  held  in  trust  by  the  United  States  Mort- 
gage and  Trust  Company  for  account  of  the  owners  until 
the  time  of  issue. 

$3,000,000  of  common  stock  is  to  be  issued  to  the 
vendors  in  part  payment  of  real  and  personal  property 
turned  over  to  the  new  company,  as  follows: 

Kingsford    $2,422,500 

Morton  255,000 

Duryea  322,500 


Total  $3,000,000 


PROMOTING   COMBINATIONS  279 

Included  in  the  property  turned  aver  by  the  vendors, 
it  is  estimated  that  there  will  be  about  $750,000  of  quick 
assets,  consisting  of  grain,  package  materials,  and  starch, 
manufactured  and  in  process. 

$500,000  in  common  stock  shall  be  paid  to  cover  the 
entire  costs  of  promoting  the  company,  including  the 
charter,  the  organization,  the  commission  paid  in  stock  for 
securing  the  loan,  the  fee  of  the  bankers  who  issue  the 
preferred. 

Common  stock  to  vendors $3,000,000 

Common  stock  to  promoters 500,000 

Total $3,500,000 

Typical  English  Combinations 

A  notev^orthy  English  combination,  effected  in  19 14,  was 
the  acquirement  of  A.  &  F.  Pears,  Limited,  manufacturers  of 
Pears  Soap,  by  Lever  Brothers,  Limited,  manufacturers  of 
"Sunlight"  and  other  well-know^n  brands  of  soap.  A.  &  F. 
Pears  had  outstanding  £320,000  ordinary  shares,  on  which 
dividends  of  12%  had  been  regularly  paid  for  some  years. 
Under  the  terms  of  the  combination,  these  ordinary  shares 
were  converted  into  12%!  cumulative  preferred  ordinary 
shares  of  the  company  of  Lever  Brothers,  Limited,  which 
rank  next  after  its  5%  debentures  and  6%.  preference  shares. 
A.  &  F.  Pears,  Limited,  then  increased  their  capital  by  issuing 
150,000  new  ordinary  shares,  which  were  purchased  by  Lever 
Brothers,  Limited,  for  £150,000.  This  £150,000  was  then 
invested  in  Lever  Brothers  15%.  preferred  ordinary  shares  at 
par;  the  market  value  of  these  shares  in  normal  times  being 
aboi^t  two  and  one-half  times  par. 

The  purpose  of  this  transfer  evidently  was  two-fold :  first, 
to  give  Lever  Brothers  all  the  voting  shares  in  A.  &  F.  Pears, 
Limited;  second,  to  provide  additional  security  for  the  con- 
tinued payment  of  the  12%  dividends  on  the  new  preferred 
ordinary  shares.    In  addition,  A.  &  F.  Pears,  Limited,  held  on 


28o  SECURING   CAPITAL 

June  30,  19 14,  investments  in  outside  securities  which  had 
cost  £220,390,  but  which  showed  a  depreciation  at  that  time 
of  about  £33,000.  It  was  agreed  that  A.  &  F.  Pears,  Limited, 
should  retain  £94,843  of  these  securities  which  could  be  held 
as  reserve  funds  to  offset  depreciation  of  the  plant  and  of  the 
leasehold  on  certain  pieces  of  real  estate. 

The  balance,  amounting  to  £125,547,  was  taken  over  by 
Lever  Brothers  in  payment  for  which  they  gave  to  A.  &  F. 
Pears,  Limited,  Lever  Brothers'  preferred  ordinary  shares  to 
the  amount  of  £55,800,  worth  at  the  market  value  of  £2  5s.  per 
share,  £125,550.  The  reason  for  this  last  transfer  was  not 
explained,  but  it  may  be  presumed  to  have  been  intended  to 
simplify  the  financial  relations  between  the  two  concerns,  and 
to  provide  still  further  security  for  the  continued  payment  of 
the  12%,  dividends  on  Lever  Brothers'  preferred  ordinary 
shares. 

The  principle  upon  which  this  combination  is  based  is  evi- 
dently that  of  assuring  the  stockholders  of  the  absorbed  com- 
pany that  they  are  to  continue  to  receive  indefinitely  the  same 
rate  of  dividends  which  they  had  been  receiving  in  the  past. 
In  other  words,  in  exchange  for  the  privilege  of  controlling 
A.  &  F.  Pears,  Limited,  and  for  the  chance  of  building  up  still 
higher  profits.  Lever  Brothers  were  willing  to  assume  all  the 
risk  of  the  undertaking. 

This  type  of  combination  is  not  at  all  unusual  when  one 
or  two  corporations  are  to  be  taken  over  by  a  previously  ex- 
isting corporation  of  high  credit  standing.  It  is  especially 
common  in  the  United  States  in  connection  with  the  long-term 
leases  much  used  by  railroad  companies.  For  instance,  the 
New  York  Central  Railroad  Company  leases  the  Boston  and 
Albany  Railroad  Company  for  a  99-year  term,  the  rental  con- 
sisting of  a  guarantee  of  8%  dividends  on  Boston  and  Albany 
stock,  plus  the  payment  by  New  York  Central  of  all  organiza- 
tion expenses,  taxes,  and  other  possible  deductions  from  Bos' 


PROMOTING   COMBINATIONS  281 

ton  and  Albany  income.  Similarly,  the  Western  Union 
Telegraph  Company  leases  the  property  of  a  subsidiary  com- 
pany for  a  50-year  term,  the  rental  consisting  of  a  5%  payment 
on  the  stock. 

Consolidations 

Sometimes  two  or  more  formerly  independent  corporations 
are  not  joined  under  one  control  by  an  exchange  of  securities, 
but  are  actually  "consolidated"  or  ''merged."  The  two  words 
just  quoted  are  sometimes  used  in  a  popular  sense  as  almost 
equivalent  to  "combined,"  but  are  here  used  in  their  legal  sense. 
A  "consolidation"  or  "merger,"  technically  speaking,  consists 
of  the  complete  union  of  one  corporation  with  another  corpora- 
tion, so  that  the  charters,  corporate  powers,  and  security  issues 
are  all  combined,  making  only  one  corporation  in  place  of  the 
two  which  previously  existed.  This  is  entirely  different,  it  will 
be  seen,  from  the  customary  process  of  keeping  alive  all  the  cor- 
porations that  enter  into  the  combination  and  simply  acquiring 
voting  control  over  those  corporations.  A  "consolidation"  or 
"merger,"  in  the  technical  sense,  is  somewhat  unusual ;  in  fact, 
this  form  is  very  seldom  used  except  when  a  railroad  or  other 
company  desires  to  take  over  in  toto  one  of  its  subsidiary  com- 
panies which  has  previously  been  the  legal  owner  of  a  separate 
piece  of  property.  The  largest  and  most  important  consolida- 
tion that  has  ever  taken  place  in  the  United  States  was  that  of 
the  New  York  Central  and  Lake  Shore  and  Michigan  Central 
Railroad  Company  in  19 14.  The  prime  purpose  in  this  case, 
it  was  stated,  was  to  make  possible  a  more  extensive  mortgage 
and  larger  bond  issues  than  could  be  brought  out  by  either  of 
the  corporations  separately. 

This  discussion  of  forms  of  combination  is  perhaps  lead- 
ing us  away  slightly  from  the  main  topic  of  methods  of  pro- 
moting combinations,  for  such  forms  as  are  treated  in  these 
sections  are  customary  only  when  the  corporations  concerned 


282  SECURING   CAPITAL 

have  previously  been  under  common  control.  The  combina- 
tion in  such  cases  could  hardly  be  regarded  as  requiring 
promotion.  Nevertheless,  a  promoter  sometimes  brings  about 
a  combination  of  a  small  independent  company  with  a  large 
and  powerful  company  by  effecting  a  lease  or  a  * 'consolida- 
tion" of  the  two. 

Analysis  of  a  Small  Combination 

In  order  to  illustrate  the  principles  treated  in  the  chapters 
on  promotion  in  a  collected  form,  and  to  show  how  they  may 
be  applied  in  practice,  it  may  be  well  to  review  briefly  the 
facts  as  to  a  small  combination  of  manufacturing  plants 
located  in  a  western  city. 

The  Western  Machinery  Company  was  organized  in  1900 
for  the  purpose  of  manufacturing  certain  patented  specialties. 
The  capital  stock  was  $150,000,  and  first  mortgage  bonds  were 
issued  to  the  extent  of  $25,000;  $100,000  of  the  capital  stock 
was  given  in  payment  for  patents,  and  $50,000  was  given  to 
the  first  promoter  for  his  services  in  disposing  of  the  bonds 
at  par.  The  $25,000  received  for  the  bonds  represented  the 
total  cash  actually  invested. 

It  was  quickly  found  that  the  business  would  not  prosper 
with  the  few  specialities  that  it  had  been  arranged  to  manu- 
facture, and  other  specialties  intended  for  the  same  general 
market  were  added.  As  a  result,  practically  all  of  the  profits 
which  were  earned  from  year  to  year  were  spent  in  securing 
new  patents  and  in  other  development.  This  continued  until 
1906,  in  which  year  a  satisfactory  profit  was  made.  However, 
the  crisis  of  1907  and  the  depression  that  followed  almost 
wiped  out  the  business  of  the  company  and  cut  down  the 
profits  practically  to  zero.  In  the  last  two  years,  however, 
there  has  been  a  recovery  and  net  profits  are  now  running 
at  the  rate  of  approximately  $20,000  per  annum.  The  char- 
acter of  the  business  has  changed  considerably  since  its  in- 


PROMOTING   COMBINATIONS  283 

ception,  but  it  may  now  be  regarded  as  established  on  a 
reasonably  sound  basis.  The  company,  however,  is  consider- 
ably handicapped,  its  location  being  unfavorable  for  the  kind 
of  business  it  is  now  handling. 

A  few  miles  distant  from  the  city  in  which  the  Western 
Machinery  Company  operates  is  a  related,  but  not  competi- 
tive, business,  owned  outright  by  a  gentleman  whom  we  will 
call  James  Smith.  He  has  a  small  plant  worth  perhaps 
$60,000,  and  is  earning  net  profits  of  about  $6,500. 

There  is  also  in  the  immediate  neighborhood  the  plant  of 
a  manufacturing  company  which  became  bankrupt  some  years 
ago.  The  plant  has  been  closed  for  over  three  years.  The 
buildings  and  other  assets,  even  in  their  present  depreciated 
condition,  are  estimated  to  have  a  value  of  well  over  $100,000, 
but  could  be  bought  for  a  much  smaller  consideration. 

The  following  plan  for  the  combination  of  the  three  plants 
above  described  was  recently  under  consideration: 

It  is  now  proposed  to  combine  these  three  plants  under  the 
name  and  charter  of  the  first-named  company,  which  is  now 
carrying  on  an  active  and  successful  business.  It  is  believed 
that  the  same  management  which  has  developed  this  business 
in  the  face  of  unfavorable  conditions  can  at  least  go  ahead 
with  the  successful  operation  of  the  plant  owned  by  James 
Smith  and  can  reorganize  and  successfully  conduct  the 
abandoned  business  of  the  company  which  formerly  owned 
the  third  plant  above  named.  James  Smith  is  willing  to  re- 
main with  the  new  organization  for  a  short  time  and  then 
retire,  so  there  are  no  personal  antipathies  or  jealousies  to  be 
overcome.  It  is  proposed  to  recapitalize  the  Western  Ma- 
chinery Company  as  follows: 

Authorized  Issue  Actual  Issue 

6%  First  Mortgage  Bonds $500,000  $150,000 

6%  Cumulative  Preferred  Stock. . .           250,000  180,000 

Common  Stock 250,000  250,000 


\ 


284  SECURING   CAPITAL 

It  is  proposed  to  distribute  these  securities  as  follows: 


Preferred       Common 


Bonds 
Western  Machinery  Company....     $30,000 

James   Smith 

Owners  of  abandoned  plant 20,000 

To  be  sold  to  the  public 100,000 


Stock 

Stock 

$100,000 

$250,000 

20,000 

40,000 

20,000 

Total $150,000        $180,000        $250,000 

It  is  anticipated  that  the  bonds,  with  a  20%  bonus  of  pre- 
ferred stock,  can  be  sold  to  an  underwriting  syndicate  at  par. 
The  syndicate  will  probably  be  able  to  dispose  of  the  bonds 
alone  at  par,  leaving  its  selling  expenses  and  profits  to  be 
covered  by  the  bonus  of  preferred.  Thus  the  company  will 
realize  $100,000  in  cash. 

It  is  further  provided  in  the  financial  plan  that  James 
Smith  shall  receive  in  addition  to  his  $20,000  preferred, 
$30,000  in  cash,  thus  leaving  $70,000  for  rehabilitation  of  the 
abandoned  plant  and  for  working  capital. 

It  is  further  provided  that  when  earnings  on  the  preferred 
stock  amount  to  as  much  as  12%,  then  the  70%  of  preferred 
remaining  unissued  at  the  time  of  organization  shall  be  dis- 
tributed as  a  bonus  in  agreed  proportion  among  the  owners 
of  the  three  plants  entering  into  the  combination. 

It  is  estimated  that  the  net  profits  of  the  combination 
should  average  at  least  $60,000,  or  approximately  three  times 
the  interest  and  preferred  dividend  payments,  at  the  outset. 
The  three  lines  of  business,  it  is  stated,  fit  together  splendidly 
and  the  combination  of  the  different  businesses  will  provide 
excellent  facilities  for  manufacturing  and  shipping  which  will 
much  improve  the  efficiency  of  the  two  going  plants  and  will 
make  possible  the  profitable  operation  of  the  abandoned  plant. 

In  an  independent  analysis  and  criticism  of  the  plan  above 
set  forth,  it  was  pointed  out  that  the  earnings  of  the  pro- 


PROMOTING    COMBINATIONS  285 

posed  combination  appear  to  be  loosely  estimated  and  that 
a  much  more  thorough  investigation  of  probable  markets  for 
the  products  of  the  combination,  of  the  selling  expenses,  and 
of  the  actual  expenditures  required  to  build  up  an  efficient 
working  organization  in  the  abandoned  plant,  would  be 
demanded  by  a  conservative  investor  before  putting  any  of 
his  money  into  the  proposition.  Unless  it  can  be  demon- 
strated, not  merely  as  a  supposition,  but  as  a  reasonable 
certainty,  that  the  earnings  will  average  $60,000  or  more, 
there  will  be  no  real  advantage  to  the  Western  Machinery 
Company  in  carrying  through  this  combination.  After  all, 
the  plant  which  they  possess  is  the  only  one  that  is  now  earn- 
ing a  considerable  volume  of  profits,  and  this  plant  will 
presumably  be  the  chief  contributor  to  the  profits  of  the  com- 
bination. 

It  is  no  doubt  true,  as  stated,  that  the  Western  Machinery 
Company  could  make  use  of  enlarged  facilities  advantage- 
ously, but  the  question  to  consider  here  is  whether  a  small 
bond  or  preferred  stock  issue,  based  upon  the  assets  of  the 
company,  would  not  provide  facilities  for  enlarging  its  opera- 
tions and  earning  more  profits  with  less  risk  than  would  be 
the  case  if  they  carried  through  the  combination.  Under 
the  proposed  plan,  the  Western  Machinery  Company  assumes 
nearly  the  whole  burden  of  risk,  must  contribute  its  own 
profits  to  the  payment  of  interest  and  dividends,  and  must 
rely  on  its  ability  to  develop  new  business  for  the  other  two 
plants  in  order  to  give  a  satisfactory  return  to  the  present 
owners  of  the  Western  Machinery  Company.  To  state  the 
case  in  slightly  different  terms,  the  most  successful  of  the 
three  companies  entering  into  this  plan  will  be  giving  up  the 
practical  certainty  of  continued,  satisfactory  profits,  for  the 
uncertainty  of  developing  a  new  enterprise. 

It  may  be  stated  in  general  terms,  that  the  wisdom  of 
combining  a  going,  successful  concern  with  an  unsuccessful 


286  SECURING   CAPITAL 

concern  may  almost  always  be  questioned.  If  the  successful 
concern  desires  to  acquire  the  assets  of  the  unsuccessful  con- 
cern, that  may  best  be  done  by  raising  cash  upon  its  own 
credit  and  purchasing  those  assets  outright.  The  situation  is 
entirely  different  from  the  one  which  exists  when  two  or 
more  going  and  successful  corporations  are  combined  on  the 
basis  of  their  earning  powers. 

On  the  strength  of  this  criticism,  it  was  agreed  that  the 
plan  was  in  all  probability  faulty,  and  it  is  understood  to 
have  since  been  abandoned.* 

Forming  a  Combination  to  Secure  Control 

It  sometimes  happens  that  the  promoters  of  a  combina- 
tion have  in  mind,  not  so  much  the  immediate  cash  profits 
which  they  may  reaUze  from  combining  and  recapitalizing 
certain  properties,  as.  the  ultimate  profits  which  they  may 
realize  through  obtaining  control  of  the  properties.  If  two 
or  more  companies  are  already  capitalized  at  a  high  figure, 
it  may  be  difficult  to  put  through  an  exchange  of  securities 
that  will  realize  much  profit;  yet  the  object  of  securing  con- 
trol with  a  very  small  expenditure  of  cash  may  be  attained. 

One  of  the  most  remarkable  illustrations  of  this  type  of 
combination  is  the  Rock  Island  Company,  which  in  191 5  went 
into  a  receiver's  hands.  The  original  company  was  the 
Chicago,  Rock  Island  and  Pacific  Railway  Company  of 
Illinois,  which  up  to  1901  had  outstanding  capital  shares 
amounting  to  $50,000,000.  In  1901  a  controlling  interest 
was  acquired  through  the  open  market  by  a  group  which  came 
to  be  known  as  the  "Rock  Island  Crowd"  made  up  of  W. 
H.  Moore,  Daniel  G.  Reid,  William  B.  Leeds,  James  H. 
Moore,  and  some  minor  participants.  With  the  exception 
of  Mr.  Leeds,  none  of  these  men  had  had  any  special  experi- 


*As  the  facts  cited  In  this  section  are  not  matters  of  public  record,  the  names 
and  some  of  the  identifying  details  are  altered. 


-  PROMOTING   COMBINATIONS  287 

ence  or  interest  in  railroad  affairs.  Their  activities  in  Rock 
Island  were  almost  wholly  in  connection  with  its  finances. 

In  June,  1901,  within  three  months  after  they  had  secured 
control,  the  capital  stock  was  increased  from  $50,000,000  to 
$60,000,000,  the  new  shares  being  sold  to  the  public  at  par. 
In  1902  the  authorized  capital  stock  was  again  increased  to 
$75,000,000  and  the  new  shares  sold  at  par.  This  $25,000,000 
was  used  to  construct  and  buy  small  lines  or  "feeders"  for 
the  railroad. 

Shortly  afterwards  a  new  corporation,  the  Chicago,  Rock 
Island  and  Pacific  Railroad  Company  of  Iowa,  was  organized 
with  an  authorized  capital  stock  of  $125,000,000,  and  an 
authorized  issue  of  collateral  trust  bonds  of  $75,000,000. 
The  collateral  trust  bonds  were  exchanged,  dollar  for  dollar, 
for  the  outstanding  capital  shares  of  the  Chicago,  Rock  Island 
and  Pacific  Railway  Company. 

At  about  the  same  time  another  new  corporation,  the  Rock 
Island  Company  of  New  Jersey,  was  incorporated  and  at  once 
issued  $96,000,000  of  common  and  $54,000,000  of  preferred 
shares.  This  $150,000,000  was  exchanged  for  the  capital 
shares  of  the  Chicago,  Rock  Island  and  Pacific  Railroad 
Company  of  Iowa.  A  peculiarity  of  the  Rock  Island  Com- 
pany of  New  Jersey  was  the  fact  that  the  preferred  stock 
elected  a  majority  of  the  board  of  directors.  Hence,  con- 
trol of  slightly  over  $27,000,000  of  the  $54,000,000  outstand- 
ing preferred  stock  would  give  control  of  the  corporation. 
Inasmuch  as  the  preferred  stock  sold  below  par  in  the  open 
market,  the  actual  cash  investment  required  was  $16,000,000 
to  $17,000,000.  As  the  stock  was  good  banking  collateral, 
a  large  part  of  this  investment  could  be  borrowed. 

It  is  evident  that  the  Rock  Island  Company  controlled  the 
Chicago,  Rock  Island  and  Pacific  Railroad  Company  of  Iowa, 
which  in  turn  had  control  of  the  Chicago,  Rock  Island  and 
Pacific  Railway  Company  of  Illinois,  the  operating  corpora- 


288 


SECURING   CAPITAL 


tion.  In  other  words,  a  relatively  slight  cash  investment 
would  be  sufficient  to  control  a  corporation  having  stock  out- 
standing of  a  book  value  of  over  $75,000,000. 

The  manner  of  holding  control  of  the  various  corporations 
included  in  this  remarkable  scheme,  is  graphically  shown 
below: 


Cash  Investment 

Required 

$16,000,000  to  $17,000,000 


Necessary  for  Control 
$27,000,000  Preferred  of  the 


Rock  Island  Company  (of  New  Jersey) 

Capital 

Shares 

Common 

$96,000,000 

Preferred 

$54,000,000 

This  Company  owned  all  the  capital  shares  of  the  1 

Chicago,  Rock  Island  and  Pacific  Railroad  Company 

(of  Iowa) 

Capital  Shares  $125,000,000 

Collateral  Trust  Bonds         75,000,000 

This  Company  had  in  its  treasury  all  the  capital  shares 

of  the 


Chicago,  Rock  Island  and  Pacific  Railway  Company 

(of  Illinois) 

Capital  Shares  increased  to  $75,000,000 


The  later  history  of  this  combination  and  its  ignominious 
end  are  discussed  in  later  chapters. 


PROMOTING   COMBINATIONS  289 

Making  Combinations  Successful 

It  may  be  remarked,  in  closing  this  chapter,  that  the 
history  of  many  of  the  large  industrial  and  of  some  of  the 
large  railroad  combinations  does  not  support  the  notion  prev- 
alent some  years  ago  that  combinations  necessarily  achieve 
economies  and  improvements  in  management.  On  the  con- 
trary, the  general  impression  which  today  prevails  among 
conservative  bankers  and  investors  is  that  most  combinations 
suffer  from  recklessness  and  inefficiency  of  management.  It 
is  clear  that  when  the  executive  organizations  of  a  number 
of  different  plants  are  suddenly  disrupted,  and  a  new  execu- 
tive organization  takes  over  at  one  time  the  management  of 
all  these  plants,  there  are  pressing  and  difficult  problems  to  be 
solved.  The  controlling  spirits  of  the  new  management  must 
be  thoroughly  trained  and  resourceful  if  they  are  able  to 
retain  the  good  features  of  the  former  managements  and  also 
add  other  good  features  which  their  larger  capital  will  enable 
them  to  command. 

Sometimes  a  combination  is  formed  under  auspices  so 
favorable  and  with  so  much  harmony  that  a  majority  of  the 
executive  talent  engaged  in  the  former  independent  concerns 
remains  with  the  combination.  If  the  leader  of  the  combina- 
tion proves  to  be  a  man  of  unusual  breadth  and  of  com- 
manding abilities,  he  may  be  able  quickly  to  build  up  a  new 
organization  which  will  be  highly  efficient.  Ordinarily,  how- 
ever, it  happens  that  the  executive  officers  of  the  former 
independent  plants,  who  are,  perhaps,  not  large  shareholders 
in  those  plants,  are  not  satisfied  to  accept  subordinate  positions 
in  the  combination.  They  prefer  to  go  into  other  lines  of 
business  or  even  to  start  competing  concerns  of  their  own. 
The  malting  combination  and  the  various  starch  combina- 
tions are  prominent  examples.  They  were  formed  to  limit 
and  forestall  competition;  their  chief  result  was  to  increase 
the  amount  and  intensity  of  competition. 


290 


SECURING   CAPITAL 


On  the  other  hand,  this  difficulty  does  not  necessarily 
arise  when  a  combination  grows  gradually  by  absorbing  one 
or  two  plants  at  a  time.  In  that  case,  the  executive  organiza- 
tion may  also  expand  accordingly  and  the  concern  will  be 
built  on  a  safe  basis. 

It  may  further  be  noted  that  the  possibilities  of  directing 
an  immense  enterprise  through  the  creation  of  a  proper  form 
of  organization  and  other  scientific  methods  of  standardizing 
and  testing  the  various  activities,  are  only  in  process 
of  development.  When  the  principles  of  organization  are 
better  understood  and  more  commonly  applied,  the  obstacles 
to  the  success  of  combinations  will  tend  to  disappear. 


I 


CHAPTER    XIII 

SELLING    SECURITIES    DIRECT 

Four  Methods  of  Selling  Securities 

When  a  corporation  is  organized,  and  usually  from  time  to 
time  during  its  life,  it  is  necessary  to  dispose  of  some  of  its 
securities.  The  initial  capital  must,  of  course,  be  raised  by  the 
sale  of  securities ;  subsequent  capital  may  come  either  by  savings 
out  of  profits  or  by  fresh  sales  of  securities.  We  shall  take  up 
for  review,  in  the  order  named,  the  four  methods  of  sale  com- 
monly used : 

1.  Allotment  to  insiders  or  to  previous  shareholders. 

2.  Direct  sale  to  the  outside  public. 

3.  Sale  to  banking  houses,  which  in  turn  dispose  of  the 

securities  by  direct  sale  to  the  outside  public. 

4.  Sale  to  banking  houses  or  brokerage  houses,  which  in 

turn  dispose  of  the  securities  through  the  machinery 
of  stock  exchanges. 

By  the  term  ''insiders,*'  as  used  above,  are  meant  all  those 
who  are  themselves  familiar  at  first  hand  with  the  affairs  of  a 
corporation  and  are  either  active  in,  or  closely  connected  with, 
the  management  of  the  corporation.  The  term  is  not  used  in 
any  derogatory  sense,  but  merely  as  a  convenient  designation 
for  those  who  have  intimate  relations,  so  to  speak,  with  the 
concern.  In  very  small  or  closely  held  corporations — assuming 
that  there  is  good  feeling  among  the  various  persons  interested 
— it  is  customary  to  allot  securities  as  they  are  issued,  to  all 
those  actively  interested  under  some  kind  of  mutual  agreement. 
The  universal  rule  of  law  is  that,  where  new  voting  shares  are 
issued  by  an  established  corporation,  every  voting  shareholder 

291 


292  SECURING   CAPITAL 

must  have  an  opportunity  to  take  up  a  proportion  of  the  new 
shares  equivalent  to  his  proportion  of  the  shares  previously 
outstanding.  Unless  there  is  some  recent  or  mutual  agreement 
to  the  contrary,  it  is  generally  found  advisable  in  close  cor- 
porations to  allot  new  issues  of  common  stock  on  this  basis. 
Preferred  stock  or  obligations  are  more  likely  to  be  sold  to 
outsiders.  There  seems  to  be  nothing  more  that  requires  ex- 
planation in  connection  with  this  very  common  situation. 

Establishing  Cordial  Relations  with  Shareholders 

Corporations  already  established  and  going  ahead  success- 
fully which  require  fresh  capital  from  time  to  time  for  expan- 
sion of  their  activities,  find  it  highly  profitable  to  spend  some 
thought  and  energy  in  cultivating  the  active  good-will  of  their 
shareholders.  This  remark  applies  especially  to  companies 
which  have  a  considerable  number  of  shareholders,  most  of 
whom  are  not  in  close  touch  with  the  management  of  the 
business.  The  man  who  has  invested  some  of  his  money  in  the 
stock  of  a  corporation  is  likely  to  feel  a  certain  personal  interest 
in  the  continued  success  and  growth  of  the  corporation;  he 
usually  likes  to  be  considered,  not  as  a  complete  outsider,  but 
as  a  person  who  is  entitled  to  some  special  information  and 
some  privileges.  Having  once  invested  in  the  corporation  and 
having  come  to  follow  its  fortunes  for  that  reason  with^  more 
than  usual  interest,  he  is  peculiarly  approachable,  if  he  is  kept 
in  an  interested  frame  of  mind,  when  a  proposition  to  make  a 
further  investment  is  brought  before  him.  In  the  language  of 
salesmanship,  two  steps — making  a  favorable  approach  and 
arousing  interest — have  already  been  taken.  The  corporation 
presumably  possesses  his  confidence.  The  succeeding  steps — 
creating  a  desire  to  invest  further  and  securing  his  decision  to 
do  so — should  be  comparatively  easy  if  he  is  in  a  position  to 
make  further  investments  in  anything. 

The  idea  of  deliberately  setting  to  work  to  cultivate  the 


SELLING   SECURITIES   DIRECT  293 

friendship  of  the  body  of  shareholders  not  identified  with  the 
management,  may  be  regarded  as  a  recent  development  in  busi- 
ness finance.  Even  yet,  there  are  comparatively  few  corpora- 
tions which  have  grasped  and  consistently  apply  the  idea.  The 
tendency  still  persists  to  regard  the  average  stockholder — 
usually  unknown  personally — as  merely  a  name  which  some 
clerk  enters  upon  the  books.  We  may  go  a  step  farther  and 
say  that  in  many  corporate  offices  he  appears  to  be  regarded 
as  an  unavoidable  nuisance  who  insists  on  draining  away  with 
his  dividend  checks — if  he  is  fortunate  enough  to  get  them — 
the  earnings  which  the  officers  and  directors  would  much  prefer 
to  retain  for  themselves.  The  truth  is  that  the  average  stock- 
holder is  a  human  being  who  likes  to  be  treated  as  such  and 
who  will  respond,  to  a  reasonable  extent,  if  the  corporation's 
relations  with  him  are  handled  with  fairness,  courtesy,  and 
some  degree  of  cordiality. 

When  the  stockholders  of  the  Northern  Pacific  Railroad 
Company  received  their  dividend  checks  in  the  early  part  of 
191 5  from  J.  P.  Morgan  and  Company,  fiscal  agents  of  the 
company,  they  were  at  least  mildly  surprised  to  find  enclosed 
an  advertising  statement  as  to  a  trip  to  the  Yellowstone 
National  Park,  which  the  railway  company  was  promoting,  and 
a  return  post  card  on  which  the  stockholder  could  inquire  for 
details  as  to  the  trip. 

The  National  Biscuit  Company  not  long  ago  sent  out  to 
their  stockholders  a  ^'Pandora  Box"  which  contained  samples 
of  many  of  the  company's  products.  The  Loose- Wiles  Biscuit 
Company  has  followed  their  example.  Swift  and  Company 
furnish  their  stockholders,  not  merely  with  a  formal  annual 
report,  but  with  a  *'Year  Book"  which  contains  a  more  intimate 
review  of  the  internal  workings  of  the  company  and  incident- 
ally recommends  that  the  stockholders  purchase  some  of  the 
company's  products.  The  American  Tobacco  Company  re- 
quests stockholders  not  only  to  call  for  the  company's  brands 


294 


SECURING   CAPITAL 


of  tobacco,  but  to  recommend  their  use  to  others.  The  United 
States  Rubber  Company  sends  to  its  stockholders  a  four-page 
folder  urging  them  to  use  United  States  tires  on  their  auto- 
mobiles.* 

A  possible  motive  for  the  advertising  efforts  above  noted 
is  to  increase  the  sale  of  the  products  of  these  corporations; 
but  it  is  probable  that  a  more  important  motive  is  to  cultivate 
the  good-will  of  the  shareholders  and  increase  their  friendly 
interest  in  the  corporation  whose  shares  they  hold.  Corpora- 
tions which  work  along  these  lines  may  safely  count  on  finding 
their  shareholders  more  responsive  the  next  time  a  new  issue 
of  securities  is  offered  to  them. 

Establishing    Cordial    Relations    with  Customers    and    Em- 
ployees 

In  discussing  this  subject  of  relations  with  shareholders, 
it  is  convenient — although  it  might  logically  come  a  little  later 
— to  treat  the  subject  of  relations  with  employees  and  with  cus- 
tomers. The  modern  corporation  with  broad-gauged  manage- 
ment is  no  longer  inclined  to  treat  its  employees  or  customers 
as  if  they  were  outsiders  entitled  to  no  special  consideration. 
On  the  contrary,  a  direct  conscious  effort  is  continually  being 
made  to  bring  them  into  sympathy  with  the  point  of  view  of 
the  management  and,  whenever  possible,  to  persuade  them  to 
participate  actively  as  shareholders  in  the  risks  and  profits  of 
the  business. 

Some  25  years  ago,  when  the  Emerson  Drug  Company 
first  put  Bromo  Seltzer  on  the  market,  its  distribution 
was  stimulated  by  giving  a  share  of  stock  in  the  com- 
pany with  purchases  of  a  certain  quantity  of  the  product 
....  and  the  Bromo  Seltzer  business  was  a  success  as 
everybody  knows  who  has  any  contact  with  the  drug 
trade.f 


*The  above  examples  were  cited  in  an  editorial  in  Printer's  Ink,  March  4,  1915. 
tFrom  an  article  in  Printer's  Ink  of  June,  1915. 


SELLING   SECURITIES   DIRECT 


295 


Many  other  companies  have  since  followed  this  example; 
but  ordinarily  they  have  made  the  mistake  of  promising  ex- 
travagant returns  which  they  were  not  able  to  realize  and 
consequently  the  whole  plan  has,  to  some  extent,  fallen  into 
disrepute.  However,  the  basic  idea  of  tying  up  the  interests  of 
customers  in  some  degree  with  the  sale  of  the  company's 
products  is  not  unsound. 

In  a  field  which  is  entirely  unrelated,  we  see  the  same  plan 
adopted  by  one  of  the  great  public  utility  corporations  of  the 
United  States — the  Pacific  Gas  and  Electric  Company.  The 
report  of  this  company  for  the  year  ended  December  31,  1914, 
states  that  a  campaign  to  induce  its  customers  to  become  further 
interested  in  the  operation  of  the  company  by  purchasing  first 
preferred  stock  had  been  successful,  $4,ckdo,ooo  of  this  stock 
having  been  taken  up  by  customers  and  over  $500,000  addi- 
tional by  employees.  In  the  first  six  months  of  191 5,  an 
additional  $1,800,000  of  the  stock  was  sold  to  1,069  customers. 
These  last  figures  show  that  the  stock  is  being  widely  distrib- 
uted in  small  blocks. 

It  is  clear  that  one  result  of  this  policy  must  be  to  secure 
a  higher  degree  of  local  public  interest  and  to  strengthen  the 
bonds  which  unite  the  corporation  in  friendly  relations  with 
the  communities  which  it  serves. 

The  same  idea  is  sometimes  used  by  local  enterprises.  The 
Twin  City  Ferry  Company  of  New  York  recently  sent  out 
a  circular  letter  which  begins  as  follows: 

This  Company  has  some  stock  to  sell  (not  much)  and 
realizing  the  advantage  of  having  our  patrons  interested 
in  the  profits  of  the  business,  I  am  writing  some  of  the 
people  who  use  the  ferry  and  consequently  know  its 
value. 

The  idea  has  been  used  again  with  success  in  securing  new 
capital  for  extending  a  moving  picture  theatre.     In  all  proba- 


296  SECURING   CAPITAL 

bility  the  policy  of  appealing  to  customers  and  prospective 
customers  could  be  applied  advantageously  in  thousands  of 
other  enterprises.  Many  an  owner  of  a  small  business  who 
chafes  helplessly  against  his  ''lack  of  capital"  and  blames  the 
''trust"  for  his  poor  success,  could  obtain  all  the  capital  he 
needs  if  he  would  work  out  a  sound  proposition  and  present  it 
by  letter  or  in  person  to  the  people  who  are  already  interested 
as  his  customers. 

The  sale  of  stock  of  a  corporation  to  its  employees  is 
usually  regarded  as  a  device  for  profit-sharing  and  as  funda- 
mentally a  method  of  cultivating  the  good-will  of  employees 
rather  than  a  method  of  raising  capital.  This  is,  in  fact,  usually 
the  case,  and  yet  we  need  not  overlook  entirely  the  other  phase 
of  the  transaction.  As  an  example  of  an  excellent  presentation 
of  an  offer  of  stock  to  employees,  we  cannot  do  better  than 
quote  below  from  a  singularly  effective  circular  sent  out  in 
March,  19 14,  by  Charles  E.  Murnan,  Secretary  of  the  United 
Drug  Company.  This  company  is  a  co-operative  corporation, 
the  stock  of  which  is  owned  by  a  large  number  of  drug  shops 
throughout  the  United  States.  The  circular  from  which  the 
following  quotation  is  extracted  was  addressed  to  drug-shop 
owners  who  are  stockholders  in  the  United  Drug  Company, 
with  the  request  that  they  bring  it  to  the  attention  of  their 
clerks : 

What  is  here  presented  is,  beyond  question,  the 
greatest  force  for  good  to  your  business  and  ours  that 
has  ever  been  set  in  motion.  It  will  aid  you  in  keeping 
good  men  when  you  find  them  because  they  have  an 
interest  to  bind   them. 

Our  7%  Preferred  Stock  has  been  sold  for  a  long 
time  at  $55  a  share,  that  is,  $110  for  two  share  lots. 
Its  intrinsic  value  is  a  great  deal  more.  I  have  induced 
our  Board  of  Directors  to  set  aside  a  block  of  this  stock 
to  be  sold  to  your  store  managers  and  clerks  at  its 
market  price,  $55  a  share,  and  allow  them  to  use   the 


SELLING   SECURITIES   DIRECT 

checks  enclosed  as  part  payment,  as  per  terms  on  back 
of  checks,  which  will  give  it  to  them  at  par,  $50,  and 
besides  they  may  pay  for  it  by  saving  a  little  each  week. 
Each  check  is  good  for  $10  credit  on  each  subscription 
for  two  shares  ($110).  They  have  ten  months  in  which 
to  pay  for  it  at  the  rate  of  $10  on  the  tenth  of  each 
month.  The  same  terms  apply  to  each  two-share  lots 
subscribed  for.  For  instance,  if  an  employee  wants  six 
shares  ($330),  he  would  use  three  $10  checks  for  a  credit 
of  $30  on  the  whole  and  pay  $30  a  month,  etc.  Subscrip- 
tions and  credit  checks  may  be  sent  at  once;  cash  pay- 
ments  begin  April   10. 

I  know  what  a  clerk  thinks  about,  because  I  have  been 
one.  I  know  what  a  salary  alone  means,  because  I  have 
been  in  that  position.  You  may  have  been  there  also. 
As  long  as  salary  is  the  only  incentive,  a  clerk  will  work 
for  little  else.  You  say  this  is  not  so  in  your  case,  be- 
cause you  have  good  fellows  who  are  loyal  and  do  the 
very  best  they  can.  No  man  does  the  best  he  can.  Each 
little  incentive  is  additional  motive  power  to  his  effort 
and,  there  being  no  corners  on  inspiration,  thereiore  no 
limit  can  be  reached.  You  cannot  get  the  best  that  is  in 
a  man  unless  he  looks  at  life  on  a  bigger  scale.  Real 
work  and  worth  are  the  result  of  ambition — ambition 
to  do  better  and  be  more. 

Anybody  who  saves  will  give  better  service  and  that 
is  what  you  need  in  your  business.  A  man's  heart  is 
where  his  interests  are.  This  inducement  is  given  to  make 
your  employees  take  more  interest  in  your  business.  They 
will  get  it  only  if  they  agree  to  save  it  and  add  more  to 
it.  We  want  them  to  have  an  interest  in  this  great 
organization  just  as  you  have,  if  only  a  small  one.  We 
are  willing  to  do  something  for  them  if  they  will  do 
more  for  you  and  they  will  do  it.  Put  this  proposition 
up  to  them  and  let  them  decide.  They  are  indebted  to 
you  for  it  because  you  have  made  it  possible. 

You  may  say  to  this  that  $110  does  not  amount  to 
anything,  that  it  is  not  enough  to  stimulate  interest  or 
additional  loyalty  or  anything  else.  You  are  absolutely 
wrong  about  it.     Fortune  has  never  yet  been  able  to 


297 


298  SECURING   CAPITAL 

establish  a  standard.  Life  is  comparative.  One  hundred 
and  ten  dollars  to  some  people  is  as  much  as  a  million 
to  others.  I  know  when  I  was  working  in  a  store,  if 
somebody  had  given  me  a  chance  to  get  some  stock  in 
one  of  the  biggest  organizations  in  the  world,  I  would 
have  been  the  proudest  fellow  in  my  town. 

Note  the  informal  tone  of  Mr.  Murnan's  circular  and  the 
skill  with  which  he  appeals  to  the  interests  of  the  proprietors 
who  should  be  pleased  to  have  their  employees  invest  in  the 
United  Drug  Company's  stock.  It  is  a  thoroughly  legitimate, 
effective  plan  for  accomplishing  two  results :  first,  disposing 
of  a  certain  amount  of  stock  at  a  fair  price ;  second,  enlisting 
the  increased  interest  of  a  class  of  men  who  can  do  much  to 
increase  the  sale  of  the  company's  products. 

While  it  is  true  that  proper  relations  with  shareholders, 
customers,  and  employees  should  be  carefully  cultivated  in 
order  to  be  in  position  to  secure  their  co-operation  and  to  sell 
them  securities  from  time  to  time,  there  is  grave  danger  in  a 
practice  which  some  concerns  have  been  guilty  of,  viz.,  that  of 
utilizing  their  lists  of  shareholders  and  customers  in  an  en- 
deavor to  sell  them  the  securities  of  other  companies.  In 
1914-1915  an  important  correspondence  school  was  subjected 
to  bitter  attacks  and  to  serious  injury  because  it  was  found  that 
its  prestige  as  an  educational  institution  had  been  used  in  order 
to  permit  its  officers  to  dispose  of  stocks  of  various  enterprises 
in  which  they  were  personally  interested. 

Grant  of  Subscription  Privileges  or  "Rights" 

Corporations  are  not  authorized,  except  under  unusual  cir- 
cumstances, to  sell  shares  of  stock  below  par.  There  is, 
however,  no  legal  objection — again  with  minor  exceptions — 
to  selling  shares  which  may  have  a  market  value  higher  than 
par,  at  par  or  at  any  price  above  par.  The  law  looks  only  to 
the  formal,  theoretical  requirement  that  the  nominal  value  of 


SELLING  SECURITIES  DIRECT 


299 


a  share  of  stock  shall  correspond  to  the  amount  of  cash  or 
property  received  in  payment  therefor. 

It  follows  that,  whenever  the  stock  of  a  corporation  has  a 
market  value  well  above  par,  the  corporation  may  issue  shares 
below  the  market  value  and  give  a  privilege,  which  is  valuable 
to  their  previous  shareholders,  to  purchase  the  new  issues  of 
stock  at  some  arbitrary  price  well  below  their  market  value. 
The  grant  of  a  subscription  privilege  or  *'right,"  as  it  is 
customarily  called,  is  one  of  the  highly  valued  perquisites  of 
stockholders  in  large  and  successful  enterprises. 

There  are  at  least  three  possible  objects  that  may  be  in  the 
minds  of  the  directors  of  a  corporation  when  they  decide  to 
grant  a  subscription  privilege  to  their  shareholders : 

1.  It  may  be  their  chief  object  to  raise  additional  capital 

by  the  sale  of  more  stock  in  the  easiest  and  least 
expensive  way ;  in  which  case  the  subscription  privi- 
lege will  probably  name  a  price  not  many  points 
below  the  market  price  of  the  stock. 

2.  The  directors  may  desire  to  give  a  special  concession 

in  the  nature  of  a  dividend  to  their  stockholders  at 
the  same  time  that  they  raise  some  additional  capital. 
In  this  case  the  subscription  price  will  probably  be 
fixed  at  a  margin  of  several  points  below  the  market 
price. 

3.  The  directors  may  wish  to  increase  the  outstanding 

stock  of  the  corporation  more  rapidly  than  the  earn- 
ings are  increasing ;  in  other  words,  they  may  desire 
to  "water"  the  capitalization  to  a  moderate  extent, 
and  at  the  same  time  to  raise  some  additional  capital. 
In  this  case  the  subscription  price  is  likely  to  be  far 
below  the  normal  market  price. 

Of  course,  it  is  common  to  find  these  three  motives  mixed 
in  varying  proportions  in  the  directors'  minds.     It  is  clear, 


300 


SECURING   CAPITAL 


however,  that  in  either  case  one  consideration  is  the  behef  that 
fresh  capital  can  be  advantageously  used  in  the  enterprise. 
For  that  reason,  we  will  consider  the  subscription  privilege  in 
this  chapter  as  if  it  were  primarily  a  means  of  securing  fresh 
capital.  It  will  be  referred  to  in  its  other  aspects  in  later 
chapters. 

In  the  remarks  above,  it  has  been  assumed  that  the  sub- 
scription privilege  is  given  .exclusively  to  common  shareholders 
and  applies  to  additional  issues  of  common  shares,  which  is  the 
ordinary  situation.  However,  it  is  not  at  all  the  necessary 
situation.  Under  some  exceptional  conditions — depending  on 
the  terms  of  their  contract  with  the  company — the  preferred 
shareholders  may  enjoy  some  subscription  privileges.  Further- 
more, the  privilege  may  be  granted  not  only  in  connection  with 
the  purchase  of  new  common  shares,  but  in  connection  with  the 
purchase  of  new  preferred  or  of  obligations. 

Following  is  the  form  in  which  a  "right"  was  granted  some 
years  ago  to  shareholders  in  the  Union  Pacific  Railroad  Com- 
pany to  subscribe  at  90%  for  4%  convertible  gold  bonds  of  the 
company,  the  market  price  of  which  was  somewhat  above  90 : 

Warrant 
$ No 

For  Subscription  to 
Twenty- Year  4%  Convertible  Gold  Bonds 

Union  Pacific  Railroad  Company 
Office  of  the  Treasurer,  120  Broadway 

New  York,  N.  Y.,  May  31,  1907. 

This  is  to  Certify  that , 

or  assigns,  is  entitled  to  subscribe  at  90%  for 

dollars,  face  value  of  the  Twenty- 
Year  4%  Convertible  Gold  Bonds  of  Union  Pacific 
Railroad   Company,    to   be   issued   in    accordance    with 


SELLING    SECURITIES   DIRECT  301 

resolutions  of  the  Board  of  Directors  adopted  May  9, 
1907,  upon  surrender  hereof,  at  this  office,  on  or  before 
July  10,  1907,  and  subject  to  the  adoption  of  a  proposed 
amendment  of  the  articles  of  incorporation  of  the  Com- 
pany at  a  special  meeting  of  the  Stockholders  called  to 
convene  June    15,   1907. 

Payment  of  such  subscription  must  be  made  as 
follows : 

Per  Per 

$1,000  bond        $500  bond 

At  the  time  of  making  sub- 
scription, on  or  before 
July   10,   1907 $200.00  $100.00 

On  or  before  August  9,  1907. .       200.00  100.00 

On  or  before  September  10, 
1907  (which  includes  ad- 
justment of  accrued  in* 
terest) 50542  252.71 

Subscriptions  may  be  paid  in  full  at  the  time  of  mak- 
ing subscriptions,  on  or  before  July  10,  1907,  in  which 
case  the  amount  payable  will  be  $901  per  $1,000  bond, 
or  $450.50  per  $500  bond,  including  accrued  interest. 

This  warrant  must  be  returned  to  this  office  on  or 
before  July  10,  1907,  accompanied  by  the  payment  of  the 
first  instalment;  and  if  not  so  returned  with  such  pay- 
ment on  or  before  said  date  will  be  void  and  of  no  value. 

Failure  to  pay  the  second  or  third  instalments  when 
and  as  payable  will  operate  as  a  forfeiture  of  all  rights 
in  respect  of  the  subscription  and  the  instalments  previ- 
ously paid. 

On  the  back  of  this  warrant  are  two  forms:  the 
first  to  be  signed  when  subscription  is  made,  and  the 
second,  which  is  an  assignment  requiring  a  witness,  to 
be  signed  if  the  privilege  is  disposed  of. 

Treasurer. 

The  reverse  side  of  the  preceding  form  appeared  as  follows : 


302  SECURING  CAPITAL 

Subscription 

1907. 

Treasurer,  Union  Pacific  Railroad  Company, 

The   undersigned  hereby   subscribes   for   the   amount 
of  bonds  covered  by  this  warrant. 

(Signature)   

(Address)  


Assignment 

1907. 

Treasurer,  Union  Pacific  Railroad  Company, 

For  value  received,  the  right  to  make  the  within  sub- 
scription is  hereby  assigned  to 

whose  address  is 

(Stockholder)   

(Address)    

Witness : 

( Signature)  

(Address)    

Note  :  For  estates  or  trust  accounts  this  assignment  must 
be  executed  by  all  the  executors,  administrators,  or 
trustees. 

These  "rights"  when  given  in  large  corporations,  are  al- 
ways transferable.  They  are  issued  as  formal  documents  which 
have  the  general  appearance  of  a  stock  certificate  and  are 
passed  from  hand  to  hand  by  indorsement  in  blank  on  the  back, 
in  the  same  manner  as  a  stock  certificate ;  consequently,  these 
''rights"  are  bought  and  sold  with  the  same  facility  as  other 
kinds  of  desirable  property. 


SELLING   SECURITIES   DIRECT  303 

Objections  to  Subscription  Privileges 

The  basic  objection  to  the  granting  of  subscription  privi- 
leges is  the  same  objection  which  applies  to  all  special  dividends 
or  bonuses — they  inevitably  give  a  speculative  character  to 
stock  which  might  otherwise  tend  to  enter  the  class  of  invest- 
ments or  semi-investments.  A  stock  receives  a  dividend,  let 
us  say,  of  8%  per  annum,  and  this  dividend  has  been  continued 
over  a  series  of  years  and  is  protected  by  an  ample  margin  of 
earnings;  naturally  the  shareholders  may  look  forward  with 
some  confidence  to  the  period  when  the  dividends  will  be 
increased  to  a  normal  level  of  10%  or  12%,  and  in  view  of 
this  expectation  the  stock  will  probably  sell  at  a  high  figure. 
We  will  suppose,  however,  that  the  directors,  in  place  of  build- 
ing up  a  surplus  and  getting  ready  for  regular  10%  dividends, 
decide  to  grant  a  special  subscription  privilege  worth  $5  to  $10 
per  share,  in  this  way  increasing  the  amount  of  capital  stock 
upon  which  dividends  must  be  paid  and  making  it  impossible 
to  expect  more  than  the  indefinite  maintenance  of  8%.  divi- 
dends. What  will  be  the  result  ?  The  shareholder,  to  be  sure, 
will  have  obtained  his  subscription  privilege,  which  is  desirable, 
but  he  will  have  lost  perceptibly  in  the  market  value  of  his 
holdings  and  he  will  have  lost  the  chance  of  a  permanent  in- 
crease in  dividends  within  the  near  future. 

On  the  other  hand,  let  us  suppose  that  the  directors  have 
raised  their  new  capital  by  having  the  preferred  stock  under- 
written at  or  about  its  market  price.  Assuming  that  this  new 
capital  could  be  used  as  advantageously  as  the  old  capital,  they 
are  in  position  to  go  ahead  a  little  later  with  the  expected  in- 
crease in  dividends. 

From  the  standpoint  of  the  permanent  owner  of  the  cor- 
poration's shares,  there  can  probably  be  little  question  but 
that  the  steady  and  dependable  dividend  policy  better  serves 
his  interests.  It  is  only  from  the  point  of  view  of  the  specu- 
lative purchaser  that  the  granting    of    special  *'rights"  and 


304  SECURING   CAPITAL 

bonuses  with  the  resulting  rapid  fluctuations  in  stock  market 
prices  is  desirable.  Sometimes,  it  may  regretfully  be  admitted, 
the  directors  of  a  corporation  find  it  to  their  personal  ad- 
vantage to  know  in  advance  that  the  granting  of  a  subscription 
privilege  is  anticipated.  On  the  basis  of  private  information, 
which  is  not  available  to  all  the  other  stockholders,  they  may 
buy  or  sell  with  the  certainty  of  making  individual  profits. 

From  the  standpoint  of  the  community  there  is  consider- 
able sentiment  against  the  granting  of  subscription  privileges 
on  the  part  of  public  service  companies  in  so  far  as  they  con- 
stitute a  method  of  stock- watering.  In  1896  the  Massachu- 
setts legislature  passed  an  act  referring  particularly  to  gas  and 
electric  light  companies,  which  includes  the  following: 

In  case  of  an  authorized  increase  of  capital  stock, 
the  shares  shall  be  offered  proportionately  to  the  share* 
holders  at  not  less  than  the  market  value  thereof  at  the 
time  of  increase.  This  value  is  to  be  determined  by  the 
Board. 

In  Great  Britain  electric  light  and  tramway  companies  may 
offer  new  shares  to  shareholders  at  par,  even  though  the  mar- 
ket value  may  be  much  higher.  The  usual  practice,  however, 
is  to  offer  the  new  shares  at  only  a  few  points  under  the  mar- 
ket value.  But  there  are  still  many  cases  where  the  share- 
holders receive  substantial  bonuses  in  the  shape  of  ''rights." 

Figuring  the  Value  of  a  "Right" 

If  a  corporation  has  a  million  dollars  par  value  of  stock 
outstanding,  with  a  market  value  of,  say,  $150  per  share,  and 
determines  to  issue  $500,000  more  of  the  same  class  of  stock, 
with  a  subscription  privilege  to  the  present  shareholders  of 
buying  the  new  stock  at  $125;  what,  under  these  conditions, 
is  the  value  of  the  ''right"  to  purchase  one  of  the  new  shares? 

At  first  glance  it  seems  obvious  that  the  answer  is  $25,  but 


SELLING   SECURITIES  DIRECT  305 

a  little  reflection  makes  it  clear  that  this  answer  does  not  take 
into  consideration  the  effect  on  the  market  value  of  all  the 
shares  produced  by  the  new  issue.  If  the  corporation  were 
to  realize  $150  from  the  sale  of  each  of  the  new  shares,  and 
if  the  new  capital  were  to  be  invested  as  profitably  as  the  old 
capital,  the  market  value  of  the  shares  would  remain  un- 
changed. But  the  company  realizes  only  $125,  and  there  must 
therefore  be  a  general  reduction  in  the  market  value  of  shares 
after  the  new  issue  has  been  brought  out.  The  question,  then, 
as  to  the  value  of  a  ''right"  requires  some  mathematical  calcu- 
lations. Perhaps  the  best  method  of  presenting  the  solution 
of  our  problem,  is  to  quote  the  following  algebraic  equations 
adapted  from  a  statement  in  the  Wall  Street  Journal: 

X  =  rights 

y  =  number    of    rights    needed    to    get 
one  share 
Selling  price  =  value  of  stock  plus  rights 
Selling  price  —  x  =  value  ex-rights 

yx  +  100  =  value  of  one  share  to  be  bought  = 

value  ex-rights 

yx  +  100  =  market  price  —  x 

yx  +  X  =  market  price  —  100 

X  (y  +  i)   --  market  price  —  100 

market  price  —  100 

^= 7+-1 

By  applying  this  formula  to  the  example  just  cited,  we 
reach  the  following  conclusion : 

150  —  100      50 
x=-j-^-—=—.=  J6.66 

The  value  of  this  "right"  is  not  therefore  $25,  as  would 
have  been  at  first  supposed,  but  $16.66.  The  same  result  may 
be  reached  by  the  arithmetical  method  as  follows: 

At  the  beginning  of  the  operation  there  is  in  existence 


3o6  SECURING  CAPITAL 

$1,000,000  par  value  of  outstanding  stock,  which  at  the  mar- 
ket value  of  $150  = $1,500,000 

The  $500,000  of  new  stock,  being  sold  at  $125, 

brings  into  the  treasury  of  the  corporation.  .  .  .    $625,000 

Aggregate  value  of  the  $1,500,000  par  value  of 
stock  outstanding  at  the  conclusion  of  the  trans- 
action =   $2,125,000 

Dividing  15,000  (the  number  of  shares  with  a  par  value 
of  $100  each)  into  $2,125,000,  we  have  the  value  of  each 
share  as  $141.66.  Inasmuch  as  the  ''right"  entitles  the  holder 
to  purchase  a  share  for  $125,  the  value  of  the  ''right"  is  the 
difference  between  $141.66  and  $125,  or  $16.66. 

It  should  be  explained  at  this  point  that  the  term  *'right" 
is  used  on  some  stock  exchanges  to  indicate  the  privilege  of 
subscribing  to  one  share  of  the  new  issue.  On  the  New  York 
Stock  Exchange,  however,  the  term  is  used  as  indicating  the 
privilege  th^t  is  granted  to  one  share  of  all  the  stock  then  out- 
standing. In  the  Hypothetical  case  above  stated,  the  "right" 
To^uy  one  share  of  a  new  issue  at  the  special  price  would  be 
granted  to  each  two  shares  of  the  formerly  outstanding  stock. 

Under  the  customary  practice  of  the  New  York  and  many 
other  stock  exchanges,  the  "right"  granted  to  each  of  the  out- 
standing shares  would  be  the  "right"  to  subscribe  to  one-half 
a  share  of  the  new  issue  at  the  special  price.  The  result  of 
the  above  calculations  should  be  divided  by  two,  therefore,  in 
order  to  give  the  value  of  the  "right"  under  the  New  York 
definition  of  the  word.  The  value  of  the  "right"  as  defined 
in  New  York  would  be,  then,  $8.33. 

Making  Use  of  a  "Right" 

A  stockholder  who  receives  a  valuable  subscription  privi- 
lege may  make  use  of  it,  according  to  his  own  circumstances 
and  judgment,  in  any  one  of  the  following  ways: 


SELLING   SECURITIES   DIRECT 


307 


1.  He  may  actually  purchase  his  share  of  the  new  issue 

at  the  special  price,  thus  making  an  especially  ad- 
/    vantageous  investment. 

2.  In  case  he  does  not  have  capital  at  hand  for  this  pur- 

pose, he  may  decide  to  sell  his  ''right"  in  the  open 
market  to  some  one  else  who  would  like  to  buy  the 
stock  or  to  speculate  in  the  value  of  these  "rights." 

3.  He  may  sell   ''short" — that  is,   without  making  de- 

livery— an  amount  of  stock  equal  to  that  which  he 
may  obtain  at  the  special  price  under  his  subscrip- 
tion privilege ;  in  this  case  he  will  later  take  up  the 
stock  to  which  he  is  entitled  and  with  this  stock 
make  his  delivery. 

The  first  method  is  desirable  if  the  stockholder  happens  to 
be  in  a  position  to  buy  of  this  particular  stock  at  the  time  the 
privilege  takes  effect.  As  most  people  keep  their  money  in- 
vested very  closely,  it  is  probable  that  most  stockholders  do  not 
make  use  of  their  privilege  in  this  manner. 

The  second  method  is  the  simplest,  and  probably  the  one 
that  is  most  used.  For  this  very  reason  it  usually  involves 
more  or  less  sacrifice.  Very  seldom  has  it  happened  that  the 
market  quotations  for  a  "right"  equal  the  theoretical  value  of 
the  "right"  as  above  calculated.  There  is  likely  to  be  a  strong 
pressure  to  make  sales  on  the  part  of  numerous  stockholders, 
with  a  limited  demand,  which  naturally  makes  a  price  that  is 
favorable  to  the  purchaser  rather  than  to  the  seller.  For  this 
reason  many  stockholders  of  considerable  means  prefer  the 
third  method.  By  selling  "short"  they  take  advantage  of  the 
optimistic  feeling  which  is  likely  to  maintain  the  price  of  the 
stock  nearly  up  to  its  former  level  during  the  period  imme- 
diately after  the  subscription  privilege  is  announced,  though 
the  theoretical  value  of  the  stock  may  have  considerably  de- 
creased.    The  stockholder  who  sells  "short"  under  these  con- 


3o8  SECURING   CAPITAL 

ditions  is  taking  very  little  risk  inasmuch  as  he  is  certain  to 
be  able  to  make  delivery  when  the  subscription  privilege  takes 
effect  and  is  usually  able  to  sell  under  the  most  favorable  con- 
ditions. 

Whether  the  shareholder  exercises  his  "right,"  sells  it  to 
some  one  else,  or  sells  "short"  and  then  delivers  his  new  stock, 
is  presumably  a  matter  of  indifference  to  the  corporation.  In 
any  one  of  these  cases,  the  stockholder  is  clearing  a  profit  and 
the  capital  which  the  corporation  desires  to  secure  has  been 
obtained. 

A  question  which  often  arises  is  whether  a  corporation 
needs  the  support  in  such  a  transaction  of  an  underwriting 
syndicate.  This  question  will  be  touched  upon  later  (Chap- 
ter XV). 

Selling  at  Auction 

We  may  next  take  up  the  case  of  a  corporation  which 
desires  to  raise  a  considerable  amount  of  new  capital  either 
at  its  organization  or  at  some  later  stage  in  its  development, 
and  which  cannot  count  on  meeting  its  needs  by  selling  to  its 
own  stockholders  or  to  those  intimately  associated  with  the 
business  as  employees  or  customers.  The  corporation,  we  will 
assume  for  the  present,  either  cannot  command  or  does  not 
desire  to  obtain  the  services  of  bankers  or  stock  exchange 
brokers,  but  wishes  to  deal  directly  with  the  prospective 
purchasers  of  its  securities.  In  other  words,  the  corporation 
is  in  the  position  of  wishing  to  sell  its  own  securities  to  the 
public  at  large  without  the  employment  of  intermediaries. 

The  simplest  method,  and  one  which  is  much  used  among 
public  utilities  abroad,  although  almost  unknown  in  this  coun- 
try, is  known  as  the  "auction"  or  "tender"  method.  The  cor- 
poration either  disposes  of  its  securities  at  public  auction,  or 
by  public  advertisement  invites  tenders  and  sells  to  the  highest 
bidders. 


SELLING   SECURITIES   DIRECT  309 

This  method  is  required  by  statute  in  England  of  all  gas 
and  water  companies.  It  is  believed  to  have  originated  with 
the  Nottingham  Gas  Company  in  1845,  and  is  now  generally 
agreed  to  be  the  most  economical  method  of  floating  new  is- 
sues, either  of  share  capital  or  of  loan  capital,  for  companies 
of  this  class.  The  so-called  "Model  Auction  Clause"  provides 
among  other  things : 

1.  That  due  notice  of  the  intended  sale  be  given  at  least 

28  days  before  the  date  of  the  auction. 

2.  That  a  reserved  price  be  fixed  and  sent  in  a  sealed 

letter  to  the  Board  of  Trade. 

3.  That  no  block  of  shares  offered  for  sale  be  of  more 

than  £100  nominal  value. 

4.  That  the  total  sum  payable  by  the  purchaser  be  due 

within  the  three  months  from  the  date  of  the  auction 
or  the  acceptance  of  the  tender. 

5.  That  any  shares  not  taken  at  the  reserved  price  may 

then  be  offered  to  previous  shareholders  and  em- 
ployees and  to  consumers. 

6.  That  any  shares  still  remaining  unsold  shall  be  again 

offered  for  sale  and,  if  unsold  after  the  second  at- 
tempt, may  be  disposed  of  at  such  price  and  in  such 
manner  as  the  directors  may  determine. 

The  well-known  firm  of  A.  &  W.  Richards  of  London 
handles  practically  all  of  the  auction  sales  of  gas  securities, 
and  sales  usually  take  place  at  the  offices  of  this  firm  on  Tues- 
day of  each  week. 

The  auction  or  tender  method  eliminates  the  immediate 
cause  of  speculative  fluctuation,  inasmuch  as  it  does  away  with 
"melon-cutting."  There  has  been  little  difficulty  in  obtaining 
plenty  of  bona  fide  bids  from  permanent  investors.  Brokers 
and  bankers  find  that  they  cannot  purchase  at  a  price  which 
will  permit  them  to  resell  at  a  profit.     There  seems  to  be  no 


3IO 


SECURING   CAPITAL 


question  but  that  the  poHcy  is  working  well  with  gas  and  water 
companies ;  yet  for  some  reason  it  is  not  applied  to  other  public 
utility  corporations. 

In  Canada,  the  Consumers  Gas  Company  of  Toronto  fol- 
lows the  same  practice.  During  the  last  several  years,  it  has 
sold  59,508  shares  of  a  par  value  of  $50  each  at  public  auction, 
the  prices  averaging  about  $200  per  share.  In  this  country 
the  plan  has  been  adopted  only  in  the  city  of  Boston,  where 
it  is  provided  that  the  new  shares  of  gas  and  electric  light 
companies  shall  be  sold  at  public  auction. 

In  view  of  the  long  continued  and  successful  experience 
of  the  English  gas  and  water  companies  in  raising  capital 
by  this  method,  it  would  appear  that  the  advisability  of  its 
further  application  to  public  utility  companies  in  the  United 
States — and  possibly  even  to  other  companies'  securities 
which  appeal  to  the  investing  public — would  be  well  worth 
careful  consideration.* 

Finding  Prospective  Buyers 

At  the  best,  however,  the  auction  and  tender  method  above 
described  is  not  applicable  to  the  great  majority  of  corpora- 
tions which  are  not  sufficiently  well  known  or  well  established 
to  secure  offers  to  buy  their  shares  and  bonds  by  the  simple 
process  of  stating  that  given  securities  are  for  sale.  They 
must  go  out  looking  for  prospective  buyers  and  must  carry 
on  an  active  campaign  for  the  purpose  of  disposing  of  their 
securities.  To  determine  the  amount  and  nature  of  the  securi- 
ties to  be  offered  belongs  to  the  field  of  financing  proper;  what 
methods  should  be  adopted  in  disposing  of  these  securities 
directly  to  investors  is  primarily  a  selling  problem.  This  prob- 
lem as  applied  to  the  sale  of  securities  can  be  analyzed  as 
follows: 


■*See  report  on  "Regulation  of  Public  Service  Companies  in  Great  Britain," 
prepared  by  Robert  H.  Whitten,  Librarian-Statistician,  Public  Service  Commission, 
State  of  New  York,  First  District,  Published  by  the  Commission,  New  York  City,  1914. 


SELLING   SECURITIES   DIRECT 


311 


1.  How  to  obtain  the  names  of  prospective  buyers. 

2.  How  to  approach  these  prospective  buyers  in  a  suit- 

able and  attractive  manner. 

3.  How  to  arouse  their  interest. 

4.  How  to  secure  their  confidence. 

5.  How  to  create  a  desire  on  their  part  to  purchase  the 

securities  that  are  being  sold. 

6.  How  to  secure  a  favorable  decision  and  consummate 

the  sale. 

It  is  necessary  here  only  to  present  a  few  remarks  as  to  the 
application  of  the  principles  of  salesmanship  to  this  problem 
of  disposing  of  securities. 

The  first  method  of  securing  the  names  of  prospective 
buyers,  which  occurs  to  many  organizers  or  managers  of  small 
corporations,  is  advertising  or  extensive  circularizing.  This 
method,  however,  has  proved  itself  almost  worthless  for  sound, 
legitimate  enterprises,  although  it  is  extensively  used  by  un- 
sound enterprises.  First  of  all,  the  very  fact  that  swindling 
promoters  of  alleged  oil  companies,  mining  companies,  and  the 
like  have  used  this  method  so  largely  is  almost  a  decisive 
argimient  against  it.  It  has  become — perhaps  unfortunately — 
so  closely  associated  with  fraud  that  any  offer  of  stocks  or 
bonds  that  is  made  through  advertising  and  circularizing  is  at 
once  looked  upon  with  suspicion  by  most  conservative  men. 
A  more  fundamental  objection  is  that  the  method  is  bound  to  be 
expensive.  It  is  not  likely  that  any  securities,  unless  they 
should  be  the  securities  of  companies  already  widely  and  favor- 
ably known,  could  be  sold  by  advertising  and  circularizing  at 
an  expense  of  less  than  25  to  40%  of  their  offered  price,  which 
is  entirely  too  high  for  a  legitimate  enterprise.  The  selling 
expense  ought  not  to  exceed  5  to  10%. 

The  plan  may  be  modified  to  the  extent  of  circularizing  only 
selected  lists  made  up,  for  example,  of  the  customers  or  prob- 


312 


SECURING   CAPITAL 


able  customers  of  the  enterprise.  If  the  list  is  carefully 
selected,  and  the  circularizing  carried  on  in  a  dignified  and 
effective  manner,  this  method  may  sometimes  prove  inex- 
pensive and  successful.  The  remarks  in  a  preceding  section  as 
to  the  advisability  of  securing  capital  from  customers  and 
employees  support  this  view.  It  must  be  borne  in  mind,  how- 
ever, that  there  is  grave  danger  here  of  arousing  the  suspicion 
that  the  corporation  is  financially  embarrassed  or  at  any  rate 
is  not  sufficiently  w^ell  financed  to  provide  funds  for  proper 
development. 

The  third  and  ordinarily  the  best  method  of  finding  pro- 
spective buyers  for  securities  of  small  corporations  is  through 
personal  inquiries.  It  may  seem  at  first  glance  that  this  state- 
ment is  in  contradiction  to  the  customary  practice  in  marketing 
commodities.  "Experience  has  long  ago  proved,"  it  may  be 
argued,  "that  making  personal  inquiries  is  a  slow  and  highly 
expensive  method  of  locating  prospective  buyers  for  auto- 
mobiles, for  real  estate,  and  for  many  other  high-priced  com- 
modities. At  any  rate  it  should  be  supplemented  and  supported 
by  advertising,  circularizing,  and  other  cheaper  methods.  Why 
should  not  the  same  principle  apply  to  the  sale  of  blocks  of 
securities  ?" 

The  answer  to  this  natural  inquiry  is  that  the  element  of 
confidence  in  the  management  of  an  enterprise  is  a  vastly  more 
important  factor  in  effecting  the  sale  of  stocks  and  bonds  than 
it  is  in  effecting  the  sale  of  a  tangible  commodity.  The  pur- 
chaser of  a  security  does  not  terminate  the  transaction  when 
he  pays  over  his  money  and  receives  his  certificate  or  his  bond. 
He  is  just  beginning  at  this  point  his  relations  with  the  cor- 
poration and  its  management.  If  he  is  wary,  therefore — and 
the  majority  of  people  with  capital  to  invest  are  wary — he  will 
not  part  with  his  capital  until  he  feels  well  assured  of  the 
honesty  and  competence  of  the  management  of  the  enterprise. 
When  the  corporation  is  well-established  and  well-known,  or 


SELLING  SECURITIES   DIRECT 


313 


when  the  offer  comes  to  him  through  a  banking  house  of  high 
standing,  or  when  he  is  personally  acquainted  with  the  man- 
agers, the  necessary  feeling  of  confidence  is  quickly  established. 
If  none  of  these  favorinsf  conditions  exist,  however,  the  best 
substitute  is  to  approach  the  prospective  buyer  with  a  personal 
introduction  or  recommendation  which  tends  to  establish  con- 
fidence. 

Here  we  have  the  basic  reason  for  the  unquestionable  fact 
that  only  through  the  personal  influence  and  activities  of  the 
responsible  officers  or  of  trusted  representatives  can  the  securi- 
ties of  a  small  corporation  be  successfully  sold  to  the  general 
public.  For  this  reason  the  expense  of  finding  prospective  pur- 
chasers through  such  impersonal  methods  as  advertising  or 
circularizing  is  in  almost  every  case  prohibitive. 

The  organizer  or  manager  of  a  small  corporation  which 
needs  capital  may  as  well  make  up  his  mind  at  once  that  he  is 
the  man  who  should  find  the  capital  and  that  he  should  work 
through  his  acquaintances  and  through  the  respected  business 
men  of  his  community  or  of  his  line  of  business.  He  may  be 
greatly  surprised,  frequently,  to  find  how  quickly  and  easily 
he  can  locate  capital,  the  existence  of  which  he  had  not  pre- 
viously suspected. 

The  Prospectus 

For  the  same  reason  that  the  seller  of  most  commodities 
needs  either  a  sample  or  a  catalogue,  the  seller  of  securities 
needs  a  prospectus.  Its  essential  characteristic  is  that  it  is  a 
written  statement  of  the  record,  the  present  condition,  and 
the  prospects  of  the  corporation  and  of  the  terms  on  which  its 
securities  are  offered  for  sale.  No  prospective  purchaser  of 
securities,  who  is  not  one  of  the  inside  managers  of  the  concern, 
will  be  likely  to  buy  until  after  a  written  statement  has  been 
put  into  his  hands  and  he  has  had  an  opportunity  to  look  it 
over.     Even  though  his  analysis  of  the  statement  may  not  be 


314  SECURING   CAPITAL 

thorough,  still  the  fact  that  it  is  made  in  writing  tends  to  in- 
crease his  confidence.  Verbal  assurances  which  he  discounts 
acquire  greater  strength  when  they  are  committed  to  perma- 
nent written  form.  The  written  statement  may  take  the  form 
of  a  private  letter;  it  may  be  a  somewhat  more  formal  type- 
written statement;  or,  if  intended  for  wider  distribution,  it 
may  be  printed.  The,  form  in  which  the  statement  is  given 
does  not  change  its  essential  character :  it  contains  the  definite 
representations  on  the  strength  of  which  the  security  is  being 
sold,  and  for  this  reason  is  of  importance  both  in  efifecting  the 
sale  and  in  connection  with  any  legal  questions  that  may  later 
arise. 

If  the  corporation  which  is  selling  the  securities  is  well- 
established  and  has  been  running  for  some  years,  the  most 
important  statements  in  the  prospectus  are  the  records  of  earn- 
ings and  the  balance  sheets.  These  figures  should  be  scruti- 
nized and  analyzed  with  the  greatest  care.  Attention  should 
be  given  to  omissions  as  well  as  to  allegations  of  fact.  The 
record  of  earnings,  for  example,  should  go  back,  not  one  or 
two  years,  but  possibly  five  or  six  years.  The  list  of  assets  in 
the  balance  sheet  should  be  checked  with  a  suspicious  eye,  and 
it  should  be  noted  whether  ample  reserves  for  depreciation  and 
loss  have  been  established.  Sometimes  it  is  claimed  that  it 
would  be  inadvisable  to  present  records  of  earnings  over  a 
period  of  years,  on  the  ground  that  this  would  be  making  public 
information  that  might  be  of  value  to  competitors.  If  the 
business  is  of  so  secret  a  character  that  even  its  records  of 
profits  are  not  to  be  made  known  to  its  stockholders  or  pro- 
spective stockholders,  it  is  certainly  not  the  kind  of  a  business 
which  should  ofifer  securities  to  the  public  at  large. 

A  common  practice  in  writing  prospectuses,  which  properly 
arouses  suspicion,  is  the  presentation  of  vague  and  plausible 
statements  that  do  not  commit  the  corporation  or  its  promoter 
to  anything  definite,  and  yet  are  intended  to  create  the  im- 


SELLING   SECURITIES   DIRECT  315 

pression  that  remarkable  profits  are  in  prospect.  In  the  pro- 
spectus of  a  small  copper  mining  company,  for  example,  it  is 
stated  that  "copper  mining  has  proved  a  source  of  some  of  the 
greatest  fortunes  the  world  has  ever  known,  and  its  possibilities 
are  not  yet  exhausted."  This  statement  is  literally  true,  and 
in  its  proper  context  is  certainly  not  objectionable.  But  when 
it  appears  in  a  prospectus,  with  the  obvious  intention  of  sug- 
gesting that  the  particular  company  which  is  offering  its  stock 
is  likely  to  prove  a  boundless  source  of  wealth,  it  may  well 
cause  suspicion  as  to  the  entire  sincerity  and  good  faith  of  the 
authors  of  the  prospectus.  Because  of  the  fact  that  glowing 
statements  beget  suspicion  rather  than  confidence,  the  writers 
of  prospectuses  for  high-grade  companies  frequently  go  to 
the  other  extreme  and  decline  to  commit  themselves  in  any 
way  as  to  the  future.  They  will  not  even  express  an  opinion. 
By  so  doing  they  may  avoid  straining  anyone's  confidence  in 
their  statements,  but  they  lose  the  persuasive  power  of  their 
own  well-founded  belief  in  the  future  growth  of  the  enterprise. 
The  skilled  prospectus  writer  will  steer  his  way  carefully  be- 
tween these  extremes. 

An  important  factor  in  creating  confidence,  especially  in  a 
new  corporation,  is  the  list  of  names  of  men  who  are  identified 
with  the  management  or  have  consented  to  join  the  board  of 
directors.  Knowing  this  to  be  true,  many  unscrupulous 
promoters  have  deliberately  set  to  work  to  secure  "ornamental" 
directors  who,  for  some  consideration  or  because  of  personal 
vanity,  are  willing  to  become  members  of  the  new  board. 

Probably  this  practice  has  prevailed  to  a  greater  extent  in 
the  organization  of  banks  than  in  any  other  line  of  business.  It 
is  unquestionably  a  vicious  practice  and  the  careful  purchaser  of 
securities  is  likely  to  be  repelled  rather  than  attracted  when 
he  sees  a  number  of  widely  advertised  names  included  in  the 
directorate. 

It  is  always  desirable  that  the  prospectus  should  be  dignified 


3i6  SECURING   CAPITAL 

in  its  form  and  in  its  contents.  Red  ink  and  buffoonery  may 
conceivably  help  to  sell  some  commodities,  but  they  will  not 
help  to  sell  thousands  of  dollars  of  stock  and  bonds.  A  man 
who  is  thinking  of  putting  his  money  into  securities,  generally 
looks  upon  the  proposition  seriously  and  does  not  ask  to  be 
either  startled  or  amused. 

However,  this  need  not  prevent  a  strong  appeal  at  times 
to  other  motives  besides  money-making.  A  trust  company  in 
a  small  Texas  city,  for  example,  which  had  been  unable  to  raise 
additional  capital  that  it  badly  needed,  found  that  it  had  no 
difficulty  in  getting  capital  as  soon  as  it  put  its  appeal  on  the 
ground  of  the  local  pride  which  should  be  felt  by  the  leading 
ranchers  and  merchants  of  the  community  in  building  up  a 
sound  financial  institution.  The  sentimental  appeal,  if  it  is 
used,  must  of  course  be  sincere  and  legitimate.  Otherwise, 
it  becomes  mere  bathos  and  a  destroyer  of  confidence. 

It  is  a  well-established  legal  principle  that  misrepresenta- 
tions or  fraud  in  the  prospectus  may  invalidate  a  subscription 
to  the  stock  which  the  prospectus  is  designed  to  sell.  It  is, 
however,  extremely  difficult  to  prove  either  misrepresentation 
or  fraud.  In  99  cases  out  of  100  they  are  merely  to  be  sus- 
pected. Very  seldom  does  the  prospectus  writer  find  it  neces- 
sary to  make  statements  that  are  directly  false.  He  insinuates 
an  untruth,  but  he  avoids  saying  it.  Even  the  most  extrava- 
gant accounts  of  the  prospectuses  of  swindling  companies  rarely 
contain  false  statements  of  fact.  Whatever  is  said  as  to  the 
future  is  merely  expressed  as  an  opinion. 

Limitations  of  Direct  Sale 

One  advantage  of  selling  securities  direct  rather  than 
through  bankers  and  brokers  is  the  belief  commonly  held  by  the 
purchasers  that  in  this  way  they  avoid  contributing  anything 
to  the  expense  of  making  the  sale.  They  argue  to  themselves 
that,  if  a  brokerage  firm  were  to  dispose  of  a  block  of  securities, 


SELLING   SECURITIES   DIRECT 


317 


it  would  require  a  commission  of,  say,  5  to  10%  or  more, 
whereas  when  the  corporation  itself,  through  its  officers  or 
direct  representatives,  disposes  of  its  securities,  no  commission 
need  be  paid.  It  is,  of  course,  obvious  that  there  is  a  fallacy 
here,  inasmuch  as  the  efTort  and  expense  on  the  part  of  the 
corporation  in  conducting  the  sale  is  just  as  truly  selling  cost 
as  would  be  a  commission  paid  to  bankers  or  brokers.  As  a 
matter  of  fact,  the  moment  direct  selling  of  its  own  securities 
by  a  corporation  gets  beyond  a  certain  limited  field,  it  becomes 
impracticable  on  account  of  its  high  cost.  We  have  already 
seen  that  advertising  and  circularizing  will  not  produce  the 
right  kind  of  inquiries  for  legitimate  propositions  except  at 
excessive  cost.  Personal  work  on  the  part  of  officers  or  pro- 
moters of  a  corporation,  who  inquire  among  their  friends  and 
proceed  from  one  man  to  another  until  they  reach  people  with 
money  to  invest,  is  also  slow  and  expensive.  The  idea  is  not 
impracticable  when  the  amount  of  capital  to  be  raised  is  com- 
paratively small;  but  as  the  amount  of  capital  increases,  the 
difficulty  and  expense  of  this  method  become  progressively 
greater. 

It  is,  of  course,  impossible  to  say  definitely  how  much 
capital  can  properly  be  raised  in  this  manner.  That  will  depend 
in  part  on  the  personal  resources  and  acquaintanceships  of  the 
officers.  Some  years  ago  the  Continental  Rubber  Company, 
which  operates  in  the  Congo,  was  organized  as  a  close  cor- 
poration by  a  small  group  of  wealthy  New  York  capitalists.  It 
had  a  capital  stock  of  $10,000,000,  all  of  which  was  readily 
secured  by  personal  solicitation.  On  the  other  hand,  an  in- 
ventor who  is  not  in  touch  with  business  men  may  find  it  a 
matter  of  great  difficulty  to  raise  a  few  hundred  dollars.  We 
can  perhaps  form  some  approximate  standard  by  considering 
the  fact  that  banking  and  brokerage  houses  rarely  care  to 
consider  undertaking  the  sale  of  securities  of  corporations 
which  are  not  capitalized  at  $1,000,000  or  more;  also,  they 


3i8  SECURING   CAPITAL 

do  not  care  to  sell  any  block  of  securities  amounting  to  less 
than  $200,000  to  $500,000  at  the  lowest.  Blocks  of  securities 
of  smaller  amounts,  therefore,  cannot  be  sold  ordinarily  in  any 
other  manner  than  through  the  personal  efforts  of  the  pro- 
moters or  managers  of  the  corporation.  Blocks  of  securities 
of  larger  amounts  can  generally,  but  not  always,  be  sold  more 
cheaply  through  banking  and  brokerage  houses  than  through 
direct  personal  efforts. 

That  there  are  some  exceptions  to  this  last  statement  will 
at  once  be  granted.  For  example,  a  large  coal  and  lumber 
company  has  recently  undertaken  to  sell  $15,000,000  6%  gold 
bonds  and  has  sent  out  a  number  of  high-grade  salesmen  who 
are  being  paid  a  10%  commission.  The  success  of  this  attempt 
is  not  yet  assured.  The  company  has  the  advantage  of  having 
well-known  business  men  at  the  head  and  of  having  large  lists 
of  dealers  to  whom  they  may  go  with  an  especially  telling  offer. 

This  general  question  of  the  relative  expense  of  various 
methods  of  selling  securities  may  be  better  considered  after 
we  have  reviewed  the  methods  of  selling  through  dealers  and 
through  stock  exchanges,  as  discussed  in  the  following  chapter. 


CHAPTER    XIV 

SELLING  SECURITIES    THROUGH    DEALERS 

Classes  of  Security  Merchants 

The  general  classes  of  security  dealers  correspond  to  the 
classes  of  dealers  in  merchandise,  as  follows: 

1.  Wholesalers 

2.  General  retailers 

3.  Retail  specialists 

It  will  quickly  appear  that  these  three  classes  are  not 
clearly  defined;  nevertheless  it  is  usually  possible  to  classify  a 
given  banking  or  brokerage  house  as  belonging  to  one  of 
these  groups.  The  wholesale  dealers  are  interested  only  in  the 
largest  issues  and  make  little  effort  to  sell  in  small  lots  direct 
to  individuals.  In  the  United  States,  J.  P.  Morgan  and  Com- 
pany, Kuhn,  Loeb  and  Company,  Speyer  and  Company,  and 
a  number  of  other  firms  not  quite  so  well-known  constitute 
this  group.  When  a  house  of  this  type  undertakes  to  sell 
a  large  issue,  it  usually  proceeds  to  form  an  underwriting 
syndicate  composed  of  firms  which  belong  wholly  or  partly 
in  the  second  group  and  which  are  equipped  to  sell  the  securi- 
ties direct  to  the  purchasing  public. 

The  second  group  includes  such  houses  as  Spencer  Trask 
and  Company ;  Harris,  Forbes  and  Company ;  White,  Weld  and 
Company,  which  maintain  large  organizations  of  bond  and 
security  salesmen  and  keep  comprehensive  and  valuable  lists 
of  people  who  are  known  to  have  money  available  for  invest- 
ment. Such  houses,  when  they  are  members  of  underwriting 
syndicates,  are  prepared  to  assume  a  large  share  of  the  burden 

319 


320  SECURING   CAPITAL 

of  actually  disposing  of  the  securities  offered.  They  may 
also  take  up  smaller  issues  of  securities  wholly  on  their  own 
account  without  forming  an  underwriting  syndicate  and  may 
dispose  of  these  issues  to  the  public.  There  is  no  sharp  line 
between  houses  in  this  group  and  houses  in  the  first  group. 

The  third  group,  consisting  of  specialists  in  the  different 
classes  of  securities,  is  more  clearly  defined.  It  is  distin- 
guished from  the  second  group  by  the  fact  that  the  list  of 
prospective  buyers  in  a  specialty  house  is  made  up  exclusively 
of  people  who  have  shown  an  interest  in  the  specialty  and 
is  not  merely  a  general  list  of  people  who  have  money  to 
invest.  The  difference  is  much  the  same  as  between  a  depart- 
ment store  and  a  retail  shop  which  specializes  in  one  line  of 
goods.  These  specialty  houses  again  differ  from  the  stock 
exchange  brokerage  firms  which  are  described  a  little  later  in 
this  chapter.  It  would  be  impossible  to  list  all  of  the 
specialty  houses.  One  deals  exclusively  in  oil  stocks ;  another 
in  the  securities  of  the  powder  companies;  another  in  equip- 
ment bonds  and  car  trusts ;  another  in  the  first  mortgage  bonds 
of  public  utilities;  another  in  bank,  trust  company,  and 
insurance  company  securities. 

We  may  also  include  in  this  third  group  a  large  number 
of  small  banking  and  brokerage  houses  scattered  over  the 
country  which  specialize  in  local  securities.  Every  city  of  any 
size  has  a  considerable  number  of  successful  corporations 
the  securities  of  which  are  from  time  to  time  bought  and 
sold.  These  local  firms  handle  business  of  this  type.  Usually 
they  are  also  the  correspondents  and  representatives  of  New 
York  houses  and  are  in  position  to  help  sell  the  big  security 
issues  in  which  New  York  is  interested. 

Handling  an  Issue 

A  brokerage  house  in  good  standing  which  undertakes  to 
sell  a  bond  or  a  stock  issue  will  first  of  all  wish  to  inform 


/ 

SELLING    SECURITIES   THROUGH    DEALERS        321 

itself  fully  and  accurately  as  to  the  soundness  of  the  issue. 
It  will  carry  on  a  preliminary  investigation  along  the  same 
lines  that  have  been  fully  described  in  Chapter  X,  **Promo- 
tion."  In  case  the  preliminary  investigation  is  satisfactory 
and  the  terms  are  agreed  upon,  the  house  will  then,  prob- 
ably through  its  own  engineers  and  accountants,  delve  still 
deeper  into  the  records  of  the  corporation  and  satisfy  itself 
beyond  a  doubt  of  the  conservatism  of  all  statements  upon 
which  the  sale  of  the  security  is  to  be  based.  Then  it  will 
proceed  to  dispose  of  the  securities.  Sometimes  an  advertise- 
ment of  the  security  will  be  approved,  and  there  may  be 
some  circularizing  with  a  dignified  prospectus.  Generally 
speaking,  the  real  object  of  this  advertising  and  circularizing 
is  probably  not  so  much  to  dispose  of  the  issue  immediately 
in  hand,  as  to  build  up  the  firm's  list  of  prospective  buyers 
of  securities. 

It  is  this  list  of  prospective  buyers  which  is  the  firm's 
chief  asset.  Having  this  list,  it  is  not  necessary  that  it  should 
continually  incur  the  great  expense  above  referred  to  of 
securing  the  names  of  prospective  buyers  through  advertis- 
ing and  circularizing;  that  is,  this  expense  is  spread  over  the 
cost  of  selling  many  different  issues  instead  of  being  charge- 
able wholly  to  one  issue. 

It  is  clear  that  so  far  as  investigation  is  concerned  the 
expense  is  almost  as  great  for  a  small  issue  as  for  a  large 
issue.  Furthermore,  the  large  issue  can  generally  be  sold  in 
larger  blocks  than  can  the  small  issue.  It  is  likely  to  be  the 
issue  of  a  better  known  corporation  and  is  more  easily  sold. 
All  three  of  these  reasons  operate  to  make  the  brokerage 
house  anxious  to  secure  the  privilege  of  selling  large  issues 
at  small  commissions,  and  reluctant  to  undertake  the  disposal 
of  small  issues  even  at  high  commissions. 

When  the  great  joint  loan  of  the  English  and  French 
governments  amounting  to  $500,000,000  was  placed  in  this 


322 


SECURING   CAPITAL 


country  in  the  fall  of  191 5,  the  bankers  accepted  for  them- 
selves a  commission  of  i>4%.  This  is  the  greatest  sale  of 
securities  and  the  smallest  commission  on  record  in  this 
country.  When  the  National  City  Bank  of  New  York  in 
the  latter  part  of  19 14  undertook  to  sell  $15,000,000  of  the 
notes  of  the  Argentine  government  in  this  country,  the  com- 
mission was  3j4%.  The  large  bond  issues  of  great  railroad 
corporations  are  ordinarily  sold  on  a  commission  of  3  to  5%. 
The  smaller  bond  issues  and  the  first-class  preferred  stock 
issues  of  industrial  concerns  are  sold  at  commissions  of  5 
to  10%.  Sometimes  commissions  go  higher,  but  that  is  not 
usual  for  the  reason  that  the  better  established  houses  do 
not  care  to  identify  themselves  with  any  security  which  re- 
quires more  than  a  10%  commission  to  cover  all  selling 
expenses  and  still  leave  a  satisfactory  profit.  It  is,  of  course, 
true  that  even  higher  commissions  and  special  bonuses  payable 
in  stock  of  the  issuing  corporation  are  not  unknown. 

When  a  brokerage  house  is  handling  a  small  issue  and 
finds  it  difficult  to  make  cash  sales,  it  may  frequently  resort 
to  "swapping"  for  other  better  known  securities  that  are 
owned  by  its  clients.  In  this  way  the  brokerage  house  may 
obtain  bonds  or  stocks  which  it  can  actually  sell  for  cash. 
The  process,  however,  is  more  or  less  risky  and  expensive 
and  amply  justifies  a  high  commission. 

Obligation  of  the  Brokerage  House 

A  question  that  is  bound  to  arise  whenever  a  bond  or 
brokerage  house  recommends  a  security  which  afterward 
turns  out  to  be  a  poor  purchase,  concerns  the  extent  of  the 
obligation  which  the  house  should  be  willing  to  assume.  So 
far  as  the  legal  obligation  goes,  the  house  is  always  careful 
to  protect  itself  by  disclaiming  responsibility  for  the  state- 
ments of  fact  which  it  transmits  from  the  corporation  to  the 
purchaser  and  by  clearly  setting  forth  that  prophecies  as  to 


SELLING   SECURITIES   THROUGH    DEALERS        323 

the  future  represent  only  its  opinions  and  not  definite 
promises.  This  attitude  is  in  itself  entirely  correct;  yet  there 
remains  a  certain  moral  obligation  which  the  better  houses 
are  quite  willing  to  recognize.  As  to  how  far  this  obliga- 
tion extends,  there  is  naturally  considerable  difference  of 
opinion. 

Clearly  there  is  rarely  a  well-marked  opposition  of  interest 
in  this  matter  between  a  well-established  banking  house  of 
high  repute  and  its  customers.  The  prosperity — the  very 
existence — of  the  house  is  dependent  upon  its  ability  to  retain 
the  unquestioning  confidence  of  a  large  number  of  investors. 
Every  time  a  security  which  it  handles  goes  wrong,  that  con- 
fidence is  perceptibly  diminished.  The  reputable  banking 
house,  therefore,  takes  great  pains  in  the  first  place  to  make 
certain  that  its  statements  of  fact  are  fully  verified  and  that  its 
recommendations  are  justified.  As  a  further  protection,  it 
is  customary  for  the  banking  house  to  obtain  for  itself  some 
kind  of  representation,  direct  or  indirect,  on  the  board  of 
directors  of  the  corporation.  It  is  thus  in  position  to  keep  it- 
self informed  and  to  exercise  some  influence  on  the  future 
policies  of  the  enterprise.  If,  in  spite  of  these  precautions, 
the  corporation's  record  is  unsatisfactory  and  the  market 
value  of  its  securities  decline,  the  banking  house  will  fre- 
quently try  to  maintain  the  market  price  and  perhaps  will 
quietly  assist  its  clients  in  disposing  of  their  holdings.  If 
the  market  decline  seems  to  be  due  to  extraneous  factors 
rather  than  to  any  real  falling  off  in  the  financial  standing 
or  profits  of  the  corporation,  the  banking  house  will  perhaps 
be  satisfied  with  doing  what  it  can  to  maintain  the  price 
and  with  reassuring  its  own  clients.  In  case  the  situation  be- 
comes worse  and  the  corporation  finally  goes  through 
insolvency  and  reorganization,  the  banking  house  will  in  all 
probability  do  its  best  to  secure  favorable  terms  for  the 
holders  of  the  securities  which  it  has  itself  recommended.     It 


324  SECURING   CAPITAL 

has  even  sometimes  happened  that  the  security  merchant  will 
repurchase  securities  which  he  has  sold  and  which  have  after- 
ward declined  in  value,  at  their  original  selling  prices;  but 
this  is  an  exceptional  case  and  is  not  to  be  expected  as  a  regular 
policy. 

On  the  whole,  as  the  investing  public  comes  to  be  better 
educated  in  financial  affairs,  and  as  the  standards  of  correct 
practice  in  these  matters  become  better  established,  there  is 
evidently  a  strong  tendency  toward  more  complete  and  un- 
questioning recognition  on  the  part  of  the  security  merchant 
of  his  moral  obligation.  The  case  is  rare  where  the  pur- 
chaser from  a  reputable  house  has  any  just  cause  for  vigorous 
complaint. 

Limitation  of  Sale  Through  Security  Merchants 

It  was  pointed  out  in  the  preceding  chapter  that  issues  be- 
low $200,000  to  $500,000  are  too  small  to  bear  the  expense 
of  thorough  investigation  on  the  part  of  security  dealers  and 
must,  therefore,  ordinarily  be  sold  direct  by  the  corporation 
or  its  promoters.  This  establishes  in  a  general  way  a  lower 
limit  of  the  security  merchant's  activities.  On  the  other  hand, 
very  large  issues  of  bonds  or  shares  which  soon  after  their 
issue  will  enjoy  an  active  market  on  an  important  stock 
exchange,  are  frequently  best  handled  with  the  assistance  of 
stock  exchange  operations.  This  does  not  mean,  as  will  be 
explained  a  little  further  on  in  this  chapter,  that  the  large 
banking  houses  do  not  underwrite  and  dispose  of  these  securi- 
ties. It  means  only  that  they  use  a  slightly  different  method. 
Speaking  in  general  terms,  it  is  usually  true  that  issues  of 
say  $10,000,000  to  $20,000,000  and  over,  are  at  once  listed 
on  the  New  York  Stock  Exchange,  and  the  efforts  of  the 
houses  which  handle  the  issue  are  directed  toward  encourag- 
ing purchases  through  the  exchange  as  well  as  toward  making 
sales  direct  to  their  own  customers.    This  is  a  method  that 


I 


SELLING   SECURITIES   THROUGH    DEALERS 


32.^ 


differs  slightly  from  the  one  that  has  been  described.  The 
figures  just  stated  give  in  a  general  way  the  upper  limit  of 
security  issues  that  are  handled  exclusively  through  the  method 
of  direct  sale  by  security  dealers  to  customers. 

Besides  paying  the  bankers'  commission,  the  issuing 
corporation  must  frequently  pay  heavy  legal  expenses  as  well 
as  fees  to  accountants,  intermediary  brokers,  and  others, 
which  run  to  a  high  figure.  Inasmuch  as  arrangements  of. 
this  kind  are  of  a  confidential  nature,  they  are  not  officially 
recorded  and  for  this  reason  it  is  difficult  to  give  exact 
figures. 

Following  is  a  statement  showing  the  expenses  incurred 
by  A.  L.  Barbour  in  1896,  in  carrying  through  the  sale  in 
London  of  £400,000  6%  debenture  bonds  of  the  New 
Trinidad  Lake  Asphalt  Company: 

Underwriting  commission,  10% £40,000 

Fee  to   City  of  London   Contract  Corporation, 

Limited,  and  to  Henry  Bell,  Esq 15,000 

Expenses  of  the  City  of  London  Contract  Cor- 
poration, Limited 1,022 

Fees  to  Seward,  Guthrie  and  Steele,  Attorneys 

.   in  New  York 2,183 

Fees  to  Ashurst,  Morris  and  Crisp,  Attorneys 

in  London 1,500 

Fees  to  accountants  and  brokers  and  miscel- 
laneous expense ."....       10,293 


£69,998 


This  Is  a  selling  expense  of  I7J^%.  It  is,  to  be  sure, 
exceptionally  high,  but  it  must  be  admitted  that  it  has  often 
subsequently  been  equalled.* 

A  further  limitation  is  to  be  found  in  the  fact  that  the 
decisions  of  security  merchants  as  to  taking  on  new  issues 

•Figures  taken  from  Dewing's  "Corporate  Promotions  and  Reorganization,"  p.  419. 


326  SECURING  CAPITAL 

are  frequently  determined  as  much  by  their  own  position  as  by 
the  intrinsic  strength  and  salability  of  the  propositions.  If  a 
banking  house  has  already  entered  into  arrangements  to  sell 
certain  issues  of  a  given  type,  it  will  not  be  in  position  to 
take  on  new  issues  of  the  same  type.  For  its  own  safety, 
it  would  prefer  to  offer  to  its  customers  a  diversified  list. 
It  has  sometimes  happened,  for  this  reason,  that  a  really 
excellent  proposition  has  been  refused  by  all  the  houses  which 
would  otherwise  have  been  glad  to  take  it  up. 

Requirements  of  the  Security  Merchant 

As  a  partial  illustration  of  some  of  the  principles  which 
have  been  set  forth  above,  it  will  be  of  interest  to  review  an 
actual  proposition  recently  presented  to  a  number  of  banking 
and  brokerage  houses,  and  to  summarize  the  reasons  which 
influenced  all  of  them  to  decline  to  take  up  the  proposition. 

Over  sixty  years  ago  two  brothers  established  a  flour  mill 
in  the  State  of  Missouri.  The  enterprise  was  successful  and 
the  brothers,  being  men  of  exceptional  ability,  took  over 
from  time  to  time  other  enterprises.  In  the  course  of  years 
they  became  very  wealthy.  It  was  agreed  between  them  that 
after  their  deaths  the  properties  which  they  then  owned 
should  be  vested  in  a  trust  and  held  intact  over  a  period  of 
years  for  the  benefit  of  their  heirs,  and  this  arrangement 
was  carried  out.  One  brother  died  about  twelve  years  ago 
and  the  other  about  ten  years  ago.  At  the  time  when  the 
proposition  was  formulated  for  presentation  to  banking 
houses,  the  period  of  trusteeship  was  about  to  end  and,  unless 
some  other  plan  were  worked  out,  the  estate  was  to  be 
appraised  and  distributed  among  the  heirs. 

The  property  held  in  trust  comprised  3,000  acres  of  land, 
a  flour  mill,  an  ice  plant,  an  electric  light  and  power  plant, 
and  a  manufacturing  establishment.  The  power  for  the 
industrial  enterprises  was  furnished  by  the  electric  light  and 


SELLING   SECURITIES  THROUGH   DEALERS       327 

power  plant,  and  they  were  also  located  so  that  they  could 
best  be  operated  under  a  single  administrative  management. 

To  break  up  the  estate  was  certain  to  involve  considerable 
loss  in  values.  Seeing  this  situation,  a  young  business  man 
of  ability  and  good  standing  in  the  community  secured  from 
the  heirs  an  option  to  purchase  the  whole  estate  for 
$1,500,000.  A  record  of  earnings  during  the  preceding  five 
years  showed  an  average  of  approximately  $120,000.  It  was 
stated,  however,  that  the  estate  had  been  loosely  managed 
and  that  by  the  use  of  modern  business  methods  it  could  be 
made  to  yield  an  annual  profit  of  at  least  $300,000.  It 
was  estimated  that  about  $500,000  cash  would  be  needed  in 
order  to  modernize  the  plants  and  to  provide  ample  working 
capital.  The  promoter  wished,  if  possible,  to  bring  out  a 
bond  issue  of  $1,500,000  and  was  himself  prepared  to  raise 
the  additional  $500,000  required  by  the  sale  of  common  stock. 

After  presentation  of  this  proposition  to  a  number  of 
bond  houses,  the  following  summary  of  their  objections  was 
drawn  up: 

1.  The  earnings  for  the  past  five  years  are  neither 
sufficiently  large  to  be  attractive  to  a  cHentele  of  small 
investors,  nor  to  guarantee  unbroken  interest  payments 
on  the  bonded  indebtedness  proposed.  In  other  words, 
if  your  outstanding  bond  issue  is  guaranteed  to  yield  6%, 
on  the  showing  made  by  the  property  for  the  last  five 
years,  you  have  too  narrow  a  margin.  The  property 
should  be  made  to  yield  earnings  at  least  twice  the  amount 
of  the  fixed  charges  before  the  proposition  would  be  in 
shape. 

2.  The  cost  to  investigate  the  reliability  of  the  entire 
property  in  all  its  phases  would  surely  be  heavy,  and 
might  be  disproportionate  if  unexpected  obstacles  were 
encountered. 

3.  The  property  has  for  about  sixty  years  been  a 
family  affair.  You  have  probably  already  met  with  hesi- 
tancy on  the  part  of  bankers  to  have  any  financial  rela- 


328 


SECURING   CAPITAL 

tions  with  matters  involving  families.  While  this  attitude 
is,  of  course,  not  always  justifiable,  it  is  unquestionably- 
true  that  the  guiding  of  a  proposition  through  the  intri- 
cacies of  family  relations  is  oftentimes  extremely 
difficult 

4.  The  fact  that  it  is  proposed  to  put  a  blanket  bond 
issue  on  several  widely  different  types  of  assets  adversely 
affects  the  proposition.  While  the  bond  issue  is  to  cover 
one  property,  it  is  easy  to  conceive  of  the  trouble  which 
might  arise  from  the  administration  of  several  highly 
different  types  of  organization  under  one  management. 
Not  only  might  this  mean  inefficiency  in  handling  these 
properties,  but  it  would  be  almost  impossible  for  the  bond- 
holders to  determine  whether  each  property  was  yielding 
a  reasonable  return  or  whether  it  was  eating  into  the 
profits  earned  by  the  other  companies. 

5.  Finally,  in  the  opinion  of  the  bankers,  the  whole 
matter  is  as  yet  in  an  embryonic  state.  It  is  now  a  capi- 
talist's, not  an  underwriter's,  opportunity.  The  proper 
plan  would  be  to  raise  at  least  $1,000,000  by  the  sale  of 
stock  and  to  pay  the  owners  of  the  estate  by  giving  them 
$500,000  in  cash  plus  a  five-year  secured  note  for 
$1,000,000,  with  the  understanding  that  within  the  fixed 
period  mortgage  bonds  would  be  sold  and  the  note  of 
the  estate  would  be  paid  off.  If  this  were  done,  the 
bonds  could  now  be  authorized,  but  would  remain  un- 
issued for,  say,  two  or  three  years  or  until  such  a  time 
as  the  company  becomes  a  smoothly-running,  well-oiled 
mechanism  showing  a  return  of  15  or  20%  on  its 
valuation.  Then,  if  the  bonds  were  offered,  we  believe 
it  would  be  a  comparatively  easy  matter  to  float  the 
issue. 

The  plan  above  outlined  did  not  prove  acceptable  and  the 
whole  project  has  since  been  dropped. 

Stock  Exchange  Methods 

Earlier  in  this  chapter  it  was  remarked  that  when  security 
issues  of  great  size  are  to  be  floated,  it  is  generally  advis- 


SELLING   SECURITIES  THROUGH   DEALERS        329 

able  to  have  them  at  once  listed  on  the  stock  exchange  and 
to  effect  at  least  a  portion  of  the  sales  through  stock  ex- 
change transactions.  One  advantage  is  that  the  ready  market- 
ability of  the  security  is  at  once  established,  thus  making  it 
easier  to  sell  it  at  a  high  price.  Another  even  more  direct 
advantage  is  the  fact  that  considerable  quantities  may  be  pur- 
chased through  the  exchange  by  people  who  are  not  listed  as 
customers  of  any  of  the  bond  houses  which  float  the  issue, 
or  who  prefer  to  buy  and  sell  through  the  exchange  rather 
than  "over  the  counter." 

Inasmuch  as  a  full  description  of  stock  exchange  methods 
and  of  the  factors  which  affect  stock  exchange  quotations 
would  require  more  space  than  is  here  available,  it  is  not 
feasible  to  do  more  than  to  give  a  brief  review  of  the  main 
facts. 

Fundamentally  an  exchange  is  simply  a  meeting  place  for 
people  who  wish  to  buy  and  sell  securities.  In  the  eighteenth 
century  the  London  coffee  houses  grew  to  be  the  natural 
centers  for  business  dealings,  and  gradually  the  custom  arose 
of  buying  and  selling  through  agents,  who  made  it  a  point 
to  meet  for  this  purpose.  It  was  a  natural  step  forward  to 
form  an  organization  of  these  agents  or  brokers  and  to 
establish  definite  hours  and  fixed  rules  to  govern  the  trading, 
and  when  that  step  was  taken  the  stock  exchange  came  into 
existence.  Much  the  same  series  of  stages  has  marked  the 
evolution  of  exchanges  in  all  the  other  principal  commercial 
cities  of  the  world.  There  are  important  exchanges  today 
not  only  in  London,  New  York,  Paris,  and  Berlin,  but  in 
Antwerp,  Rotterdam,  Vienna,  Petrograd,  Buenos  Aires,  Rio 
de  Janeiro,  Valparaiso,  and  numerous  other  cities.  Within 
the  United  States  the  chief  exchanges  outside  of  New  York, 
are  in  Boston,  Philadelphia,  Baltimore,  Cleveland,  Cincinnati, 
Chicago,  New  Orleans,  and  San  Francisco.  This  is  by  no 
means  a  complete  list.    Even  some  of  the  smaller  cities,  such 


330 


SECURING   CAPITAL 


as    Rochester,    New   York,    have    stock    exchanges    of   some 
importance. 

All  the  exchanges  are  organized  on  the  same  general  plan. 
They  are  non-stock  corporations,  similar  in  their  essential 
constitution  to  clubs.  Members  are  admitted  on  payment  of 
dues,  provided  a  membership  or  "seat"  has  been  purchased 
from  some  member  who  wishes  to  retire.  The  mere  fact 
that  membership  has  been  purchased,  however,  is  not  suffi- 
cient in  itself  to  guarantee  admission.  The  membership  com- 
mittee may,  for  any  reason  that  it  sees  fit,  decline  to  accept 
the  applicant. 

Seats  on  the  leading  stock  exchanges  frequently  sell  at 
very  high  figures.  Their  value  is  apt  to  fluctuate  a  great 
deal  from  time  to  time,  depending  upon  the  amount  and  profit- 
ableness of  the  business  which  is  being  handled  by  the  ex- 
change. A  price  of  $70,000  to  $80,000  for  a  seat  on  the 
New  York  Stock  Exchange  is  not  uncommon,  though  within 
recent  years  as  little  as  $30,000  has  been  paid. 

The  brokers  who  hold  membership  on  an  exchange  are 
required  to  charge  standard  commissions  for  buying  and  sell- 
ing. On  the  New  York  Stock  Exchange  the  brokerage  on 
each  transfer  of  a  security  is  %%  of  the  par  value,  or  $1.25 
per  thousand  dollars;  thus  the  normal  difference  between  the 
buying  price  and  the  selling  price  of  a  stock  exchange  security 
is  34%-  On  the  London  Exchange,  brokers'  commissions  are 
determined  by  individual  firms  and  have  not  been  so 
definitely  standardized.  The  buying  and  selling  of  securities 
often  reach  an  enormous  volume;  for  instance,  million-share 
days  on  the  New  York  Stock  Exchange  are  by  no  means 
uncommon.  Naturally,  much  of  the  buying  and  selling  is 
at  once  offset  by  a  corresponding  resale  or  repurchase.  A 
certain  portion  of  the  brokers  are  known  as  "scalpers'*  and 
make  it  their  sole  business  to  take  advantage  of  quick  fluctua- 
tions in  prices.     A  broker  of  this  type  may  buy  1,000  shares 


SELLING   SECURITIES  THROUGH   DEALERS 


331 


with  the  full  intention  of  reselling  within  a  few  minutes  or, 
at  any  rate,  before  the  close  of  the  day.  He  is  satisfied 
if  he  makes  a  profit  of  ^  to  ^  on  the  transaction. 

Other  members  of  the  Stock  Exchange  seldom  or  never 
appear  on  the  floor,  but  operate  entirely  through  their  fellow 
brokers.  The  advantage  to  them  of  membership  lies  in  the 
fact  that  the  regular  commission  on  transactions  for  fellow 
brokers  is  reduced  to  the  very  low  figure  of  $2  per  hundred 
shares.  By  far  the  great  majority  of  the  brokers  do  little  or 
no  buying  and  selling  on  their  own  account,  but  are  satisfied 
with  handling  the  orders  given  them  by  their  customers. 

On  the  London  Stock  Exchange  there  are  two  classes  of 
traders,  known  as  ''jobbers"  and  "brokers."  The  broker  deals 
with  outside  customers  and  turns  over  the  actual  filling  of  the 
order  to  the  jobber.  On  the  New  York  Stock  Exchange 
the  transactions  of  every  day  are  "cleared"  at  the  end  of  the 
day.  That  is  to  say,  purchases  and  sales  of  the  same  security 
are  checked  off  against  each  other  so  that  there  need  not  take 
place  the  vast  amount  of  handing  certificates  from  hand  to 
hand  which  would  take  place  if  every  sale  were  to  be  accom- 
panied by  an  actual  delivery.  After  purchases  and  sales 
have  been  checked,  there  remains  only  a  comparatively  small 
residue  of  actual  deliveries  required  in  order  to  close  the  day's 
transactions.  On  the  London  Stock  Exchange  the  period 
of  settlement  comes  only  once  a  fortnight.  Three  days  are 
allowed  for  checking  up  and  turning  in  records  of  purchases 
and  sales,  for  giving  to  brokers  the  names  of  the  people 
to  whom  their  certificates  are  to  be  transferred,  and  for 
making  payment  and  accepting  delivery.  This  complex 
machinery  is  required  partly  because  of  the  English  practice 
of  registering  the  names  of  all  holders  of  securities.  Securi- 
ties to  bearer  or  securities  under  the  American  plan  of 
requiring  only  indorsements  in  blank,  can  be  much  more 
easily  handled. 


332  SECURING   CAPITAL 

Importance  of  Speculative  Dealings 

It  is  doubtless  well  known  to  the  readers  of  this  volume 
that  the  great  mass  of  transactions  on  most  of  the  exchanges 
have  a  speculative  character.  A  great  many  securities,  to  be 
sure,  are  actually  taken  out  of  safe  deposit  boxes  and  brought 
into  the  market  to  be  sold  outright,  and  a  great  many  securi- 
ties are  every  day  purchased  to  be  held  as  permanent  invest- 
ments; yet  the  speculative  buying  and  selling  overshadows 
investment  buying  and  selling. 

The  activities  of  the  "floor  traders"  or  "scalpers"  who  buy 
and  sell  for  a  profit  of  ^  to  ^  %  have  been  mentioned.  Many 
of  these  traders,  though  not  all,  make  it  a  point  to  match 
all  their  purchases  and  sales  before  the  end  of  every  busi- 
ness day,  thus  reducing  their  risk  of  heavy  loss  to  a  minimum. 
These  men  proceed  almost  as  much  by  intuition  as  by  rea- 
soning. If  they  see  in  the  manner  of  bidding  of  other 
brokers,  or  "feel  it  in  the  air,"  that  a  given  security  is  tend- 
ing upward,  they  will  help  along  the  movement  by  making 
a  purchase  with  the  expectation  of  reselling  a  little  later  at 
a  slight  profit.  One  result  of  their  activities  is  to  concentrate 
attention  and  the  volume  of  transactions  on  a  few  active 
securities.  Their  business  thrives  on  rapidity  of  fluctuation  in 
prices.  However,  their  operations  tend  to  restrict  the  range  of 
fluctuation  for  they  are  ready  to  buy  on  a  momentary  drop  in 
price  or  to  sell  on  a  momentary  rise,  and  to  resell  or  rebuy  as 
soon  as  the  normal  level  is  again  reached. 

A  second  group  of  speculators  consists  of  brokers  and  of 
others  who  are  in  close  relation  with  the  Wall  Street  market 
and  who  carry  on  buying  and  selling  campaigns  with  the 
expectation  of  "cashing  in"  within  a  few  weeks  or  months. 
Sometimes  a  group  of  these  operators  will  form  a  syndicate 
for  the  purpose  of  "bulling"  or  "bearing"  the  price  of  a 
security.  Through  "matched"  orders  for  buying  and  selling 
they  create  an  artificial  activity,  and  bring  about  great  changes 


SELLING    SECURITIES   THROUGH    DEALERS 


333 


in  quotations.  Their  calculation  is  that  sooner  or  later  out- 
siders will  be  attracted  by  the  movement  and  will  endeavor  to 
go  along  with  it.  By  gradually  feeding  out  or  repurchasing 
the  security  in  which  they  are  interested,  they  may  be  able  to 
clear  a  large  profit  for  themselves. 

A  third  group  of  speculators  consists  of  men  who  possess 
a  real  or  fancied  knowledge  of  the  intrinsic  value  of  a 
security,  and  who  buy  or  sell  when  the  market  price  is  a 
considerable  distance  away  from  what  they  believe  to  be  the 
normal  price,  in  the  expectation  that  at  some  later  date  the 
normal  price  will  be  reached  and  they  may  realize  a  profit. 
Included  in  this  group  are  officers  and  directors  of  corpora- 
tions the  securities  of  which  are  listed  on  the  exchange,  who 
should  be  in  position  to  know  more  about  the  real  standing 
and  probable  future  showing  of  their  corporation  than  any- 
one else.  Unfortunately  for  these  men,  it  frequently  happens 
that  they  do  not  give  proper  weight  to  general  market 
influences  which  affect  the  whole  general  level  of  security 
prices.  It  is  not  at  all  an  uncommon  case  for  a  man  who  is 
thoroughly  well  acquainted  with  a  given  corporation  to  form 
an  entirely  mistaken  idea  as  to  the  market  value  of  its 
securities. 

A  fourth  group  of  speculators  consists  of  the  "lambs"  who 
are  not  equipped  with  the  experience  and  insight  of  the  "floor 
traders,"  do  not  possess  the  knowledge  of  market  conditions 
and  financial  resources  of  the  larger  operators,  and  are  not 
acquainted  with  given  securities  as  corporation  officials  are. 
For  the  most  part  they  simply  gamble  on  the  strength  of 
"tips"  or  of  hazy  impressions ;  and  it  can  never  be  more  than 
a  temporary  accident  if  they  happen  to  make  profits.  The 
number  of  these  people  and  the  volume  of  their  transactions  is 
often  exaggerated,  but  their  losings  nevertheless  provide  a 
steady  source  of  revenue  for  the  better  informed  and  more 
skilful  speculators. 


334  SECURING  CAPITAL  '  \ 

Making  a  Market 

In  disposing  of  securities  through  stock  exchange  opera- 
tions, it  is  essential,  first  of  all,  that  public  interest  should  be 
aroused  and  that  the  volume  of  transactions  should  be  of 
sufficient  size  to  attract  attention;  otherwise  the  speculative 
buying,  which  constitutes  the  great  bulk  and  which  must  be 
relied  upon  to  take  the  new  securities  off  the  hands  of  the 
syndicate  managing  the  flotation,  will  be  lacking. 

"Making  a  market"  is  accomplished  chiefly  through  two 
lines  of  effort;  first,  through  providing  for  a  sufficient  volume 
of  transactions  to  arouse  the  interest  of  brokers  and  pro- 
fessional stock  market  operators  who  in  such  a  case  will  buy 
and  sell  in  the  hope  of  making  substantial  profits  out  of  the 
fluctuations.  When  the  market  for  a  given  issue  is  success- 
fully manipulated,  the  volume  of  transactions  will  become 
so  large  that  the  syndicate  carrying  through  the  flotation — 
which  probably  will  be  engaged  simultaneously  in  buying  and 
selling  so  as  to  gain  a  control  over  the  price — should  find 
it  possible  to  sell  every  day  during  the  movement,  a  little 
more  than  it  buys.  Thus  it  will  gradually  get  rid  of  its 
own  holdings  without  causing  a  fall  in  the  price.  At  the 
same  time,  through  direct  sales  outside  the  exchange,  which 
will  be  facilitated  by  the  excellent  quotations  on  the  exchange, 
it  will  probably  dispose  of  the  rest  of  its  holdings. 

The  second  essential  factor  in  making  a  market  is  favor- 
able publicity.  When  a  new  security  is  to  be  brought  out 
and  listed  on  the  stock  exchange,  it  is  generally  the  case  that 
for  some  weeks  or  possibly  for  some  months  in  advance,  the 
financial  press  and  the  financial  pages  of  the  daily  newspapers 
are  liberally  supplied  with  press  notices  intended  to  arouse 
glowing  visions  of  the  prosperity  of  the  corporation.  Let 
us  take  a  concrete  example.  Beginning  early  in  the  summer 
of  1914,  news  items  began  to  appear  relating  to  the  intended 
formation  of  the  Sterling  Gum  Company,  which  was  to  put 


SELLING   SECURITIES   THROUGH    DEALERS 


335 


on  the  market  some  new  brands  of  chewing  gum.  The 
names  of  some  business  men  of  good  standing  were  men- 
tioned as  being  the  organizers  and  prospective  directors  of 
the  new  company.  Throughout  the  summer  and  fall,  such 
items  as  the  following  frequently  appeared: 

An  official  of  the  Sterling  Gum  Company  says:  "Our 
selling  campaign  is  now  well  under  way.  The  reception 
accorded  our  brands,  both  new  and  old,  here  and  in 
Canada,  has  exceeded  our  greatest  expectations.  Repeat 
orders  within  a  few  days  after  first  allotment  have  been 
the  rule  rather  than  the  exception." 

The  Metropolitan  Tobacco  Company,  the  largest 
tobacco  jobber  in  the  United  States,  is  handling  Sterling 
brands  in  the  New  York  district,  and  its  report  to  the 
Sterling  Gum  officials  has  been  of  unusually  big  sales 
in  and  about  New  York  City. 


Sterling  Gum  Company  has  one  brand  which  it  is  sell- 
ing exclusively  in  Canada.  This  brand  is  manufactured 
in  Toronto.  Its  selling  agent  there  reports  its  initial  sale 
the  largest  of  any  newly  introduced  gum  in  the  history 
of  the  Dominion.  Those  who  are  directing  the  affairs 
of  the  Sterling  Gum  Company  state  that  the  "inserts'* 
similar  to  those  being  used  by  many  of  the  large  tobacco 
companies,  are  proving  as  efficient  a  means  of  pushing 
new  gum  brands  as  they  proved  in  the  selling  campaign 
of  brands  of  tobacco  goods. 


The  new  plant  of  the  Sterling  Gum  Company  in  Long 
Island  City  will  be  a  five-story  factory  building  on  the 
south  side  of  Harris  Avenue  between  Ely  Avenue  and 
William  Street.  It  will  be  a  modern  fireproof  steel 
structure  to  cost  in  the  neighborhood  of  a  quarter  of  a 
million  dollars.  The  Sterling  Gum  Company  has  taken  a 
long  term  lease  at  an  aggregate  rental  in  the  neighbor- 
hood of  $300,000.  The  plant  will  be  ready  for  occupancy 
about  April  i,  1915.  It  will  be  opened  with  a  force  of 
over  1,000  employees. 


336  SECURING   CAPITAL 

The  common  stock  of  this  company  was  finally  brought 
out,  and  perhaps  under  ordinary  circumstances  the  interest 
that  had  been  aroused  would  have  been  sufficient  to  assure 
it  a  ready  market  at  a  satisfactory  price.  Unfortunately, 
however,  the  outbreak  of  the  war  and  the  resulting  unfavor- 
able financial  conditions  upset  these  calculations,  for  there 
appeared  in  the  Wall  Street  Journal  of  October  15,  1914,  the 
following  inconspicuous  item: 

The  Sterling  Gum  Company  syndicate  scheduled  to 
dissolve  on  September  15,  has  been  extended  to  June 
15  next.  Notices  to  this  effect  will  be  sent  out  in  a 
few  days.  This  syndicate  underwrote  $2,000,000  of  the 
Sterling  Gum  Company  stock. 

Limitations  of  Sale  Through  Stock  Exchanges 

On  the  basis  of  the  brief  descriptions  above  given,  it  is 
apparent  that  floating  new  issues  exclusively  through  stock 
exchange  operations  is  a  somewhat  uncertain  process,  and 
moreover  is  suitable  only  for  securities  of  a  distinctly  specula- 
tive character.  The  expense  and  risk  of  floating  a  com- 
paratively small  issue  by  this  method  are  seldom  justified. 

Just  how  expensive  an  operation  of  this  character  is  likely 
to  prove  is  a  question  that  cannot  be  satisfactorily  answered. 
It  is  evident,  however,  that  even  though  it  may  be  completely 
and  quickly  successful,  there  must  be  a  large  outlay  for 
brokerage  commissions  alone.  The  buying  and  selling  trans- 
actions must  total  a  great  many  times  the  nominal  value 
of  the  issue  which  is  being  floated,  and  a  commission  of  J^% 
on  each  transaction  may  easily  amount  to  a  considerable  sum. 
In  addition,  the  risk  undertaken  by  the  underwriting  syndicate 
must  necessarily  be  offset  by  the  possibility  of  earning  a  large 
profit.  On  the  whole,  it  is  questionable  whether  the  average 
expense  of  selling  by  this  method  is  any  less  than  by  the 
other  methods  that  have  been  described. 


SELLING    SECURITIES   THROUGH    DEALERS        337 

It  does  not  follow,  however,  that  every  new  security  which 
is  listed  on  the  stock  exchange  and  immediately  becomes 
active  is  in  process  of  flotation  through  stock  exchange 
manipulation.  It  is  often  the  case  that  the  security  is  listed 
simply  as  an  incident  to  its  flotation,  and  is  allowed  practically 
to  take  its  own  course  except  for  receiving  some  support 
from  time  to  time  in  case  its  price  tends  to  sag  below  the 
direct  *'over  the  counter"  price.  In  this  case  the  fact  that  the 
security  is  listed,  and  that  its  quoted  price  is  slightly  above 
the  "over  the  counter''  price,  is  a  powerful  and  legitimate  aid 
in  selling  the  security.  There  can  be  no  question  but  that 
any  security  which  enjoys  the  advantage  of  being  listed  and 
of  having  a  regular  market  is,  for  that  very  reason,  worth 
more  than  a  security  of  equally  high  intrinsic  value  which  is 
not  so  readily  marketable. 

It  should  be  mentioned  in  this  connection,  that  the  faulty 
banking  system  which  existed  in  the  United  States  prior  to 
the  inauguration  of  the  Federal  Reserve  Act  in  November, 
19 1 4,  tended  to  concentrate  call  loan  money  in  the  New  York 
market  and  thereby  fostered  speculation  on  the  New  York 
Stock  Exchange.  The  result  was  an  overconcentration  of 
interests  on  a  limited  number  of  large  and  highly  speculative 
issues,  to  the  detriment  of  other  issues.  On  the  London  and 
other  stock  exchanges  this  tendency  is  not  so  prominent;  on 
the  contrary,  vast  numbers  of  securities  issued  by  govern- 
ments and  corporations  in  all  quarters  of  the  world  are  dealt 
in,  and  the  interest  of  the  purchasing  public  is  spread  with 
some  degree  of  uniformity  over  the  whole  list. 

It  is  greatly  to  be  hoped  that  under  the  new  banking  system 
in  this  country  a  similar  decentralization  of  call  loan  money 
and  of  speculative  interest  will  take  place.  If  this  proves  to 
be  the  case  the  great  gambling  operations  in  speculative 
issues  will  become  a  less  prominent  feature  of  the  stock 
markets  and  the  volume  of  actual  buying  and  selling  will 


338  SECURING   CAPITAL 

proportionately  increase.  This  tendency  will  favor  many  of 
the  smaller  stock  exchanges  of  the  country,  and  especially 
will  tend  to  favor  the  smaller  corporations  which  have  previ- 
ously been  unable  to  secure  for  themselves  the  attention  that 
their  securities  deserve. 


CHAPTER    XV 

UNDERWRITING 

Origin  of  Underwriting 

The  practice  of  underwriting  security  issues  has  been  re- 
ferred to  from  time  to  time  in  previous  chapters.  It  has  been 
assumed  that  every  reader  is  acquainted  in  a  general  way  with 
the  meaning  of  the  term,  but  a  more  detailed  discussion  is 
presented  in  the  present  chapter. 

The  practice  of  underwriting  arose  in  connection  with 
shipping  ventures  during  the  seventeenth  century.  The  lead- 
ing ship  merchants  of  London  were  accustomed  to  assembhng 
in  Lloyd's  Coffee  House  to  transact  their  mutual  business.  In 
the  course  of  time,  the  custom  arose  of  dividing  the  risk  of 
venturesome  voyages  among  a  number  of  different  merchants, 
each  one  agreeing  to  stand  a  fixed  share  of  the  loss  or  to 
receive  a  proportionate  share  of  the  profits.  The  contract  to 
this  effect  was  passed  about  and  each  merchant  who  agreed 
to  it  wrote  his  name  under  the  contract — hence  the  word 
''underwriting."  As  is  well  known,  the  term  is  used  chiefly 
in  relation  to  the  distribution  of  insurance  risks ;  though  when 
applied  to  bond  and  share  issues  the  essential  thought  is  the 
same,  namely  that  of  distributing  the  risk. 

Perhaps  it  would  be  more  correct  to  say  that  the  under- 
writing contract  generally  relieves  the  corporation  which  issues 
the  security  of  all  risk.  As  will  be  explained  a  little  later, 
there  are  a  number  of  different  types  of  underwriting  agree- 
ments, but  they  all  possess  the  feature  that  a  banking  house  or 
a  group  of  banking  houses  undertakes  that  the  corporation 
receive  not  less  than  an  agreed  sum  for  the  whole  issue  within 
a  fixed  period.    The  underwriters  obligate  themselves  to  take 

339 


340 


SECURING   CAPITAL 


over  the  issue  themselves  in  case  it  cannot  be  sold  to  the  public 
above  the  agreed  price. 

Importance  of  Underwriting  in  Present-Day  Financing 

The  advantages  of  this  arrangement  to  a  corporation  are 
well  worth  a  considerable  sum  of  money.  In  the  first  place, 
an  issue  once  underwritten  is  an  assured  success.  The  cor- 
poration may  at  once  proceed  with  whatever  projects  the  fresh 
capital  is  designed  to  finance.  There  is  no  tedious  and  costly 
period  of  waiting  during  which  the  securities  are  in  process 
of  being  sold.  Many  new  enterprises  are  of  such  a  nature  that 
time  is  an  important  element  in  making  them  successful.  If, 
for  example,  a  new  plant  is  being  built  in  order  to  handle 
certain  contracts,  or  if  an  effort  is  being  made  to  forestall 
competition,  it  might  be  fatal  to  the  project  if  its  inception 
were  delayed  until  after  all  the  stock  or  bonds  have  been  sold. 

A  second  highly  important  advantage  is  that  underwriting 
assures  success  in  raising  the  entire  sum  called  for.  Frequently 
any  amount  less  than  the  entire  sum  would  be  a  burden  rather 
than  a  source  of  strength  to  the  corporation.  For  examxple, 
a  company  operating  department  stores  intends  to  establish 
a  new  store  on  a  large  scale  in  another  city.  The  stores  pre- 
viously owned  are  developed  as  far  as  can  profitably  be  done. 
To  establish  the  proposed  new  store  with  insufficient  capital 
would  be  merely  to  make  it  second-rate  and  to  invite  quick 
failure. 

Let  us  suppose  that  the  company,  which  needs  $1,000,000 
for  the  new  store,  authorizes  an  issue  of  additional  stock  for 
that  amount,  and  sells  only  one-half  the  stock,  thus  raising 
$500,000.  It  is  then  in  a  position  where  it  can  go  neither 
forward  nor  backward.  It  cannot  very  well  return  the  money 
which  has  been  raised,  nor  can  it  proceed  with  the  upbuilding 
of  the  new  store.  It  is  possible,  in  a  case  of  this  kind,  to  take 
subscriptions  to  the  new  issue,  the  subscription  agreement  pro- 


UNDERWRITING 


341 


viding  that  it  shall  not  be  binding  unless  the  complete  issue 
is  subscribed  for  within  a  given  period.  However,  this  intro- 
duces an  element  of  uncertainty  that  interferes  with  effecting 
the  sale  of  the  security  issue.  Underwriting  protects  the  cor- 
poration against  all  risk  and  difficulty  of  this  nature.  It  can 
be  certain  of  receiving  the  amount  of  capital  that  is  agreed 
upon  within  a  definite  period. 

Incidentally,  the  underwriting  agreement  carries  with  it 
the  advantages  that  go  with  all  other  arrangements  whereby  a 
banking  house  agrees  to  market  the  securities  of  a  corporation. 
The  corporation  gets  the  benefit  of  the  specialized  experience 
and  judgment  of  the  bankers,  and  thus  the  risk  of  making  a 
serious  error  in  the  form  or  in  the  price  of  the  new  security 
is  reduced  to  a  minimum. 

Not  only  is  the  underwriting  agreement  advantageous  to 
the  corporation,  but  also  to  the  purchasers  of  the  security  issue. 
In  the  first  place,  the  fact  that  an  underwriting  syndicate  has 
been  formed — provided  'it  is  made  up  of  first-class  houses — • 
is  in  the  nature  of  a  guarantee  that  the  security  is  sound.  A 
still  greater  advantage  is  the  insurance  of  the  purchaser  of  the 
security  against  the  same  contingencies  which  would  be  harm- 
ful to  the  corporation ;  for  it  must  be  borne  in  mind  that  the 
moment  the  purchaser  becomes  a  stockholder  or  a  bondholder 
in  the  corporation,  he  begins  to  share  in  its  good  or  evil 
fortunes.  If  the  corporation,  therefore,  is  injured  by  dragging 
out  the  sale  of  a  new  security  issue  over  a  long  period,  or  by 
bringing  out  a  security  issue  which  finally  is  not  entirely  dis- 
posed of,  the  purchaser  of  the  securities  is  one  of  the  sufferers. 
It  is,  therefore,  to  his  advantage  that  the  issue  should  be  under- 
written and  its  success  thereby  assured. 

The  Underwriting  Syndicate 

We  have  seen  that  originally  underwriting  consisted  in 
the  distribution  of  the  risk  among  several  different  merchants. 


342  SECURING   CAPITAL 

This  remains  a  characteristic  feature  of  present-day  financial 
underwriting.  It  is  true  that  the  term  is  frequently  applied 
to  an  agreement  between  a  corporation  and  a  single  banking 
house,  under  which  the  banking  house  agrees  to  take  over  a 
block  of  securities  at  a  given  price.  A  transaction  of  this  type 
may  better  be  called  a  sale — or,  at  any  rate,  a  contract  of  sale — 
rather  than  an  underwriting.  However,  an  arrangement  of 
this  kind,  in  which  only  one  banking  house  is  involved,  is 
practically  unknown  except  to  cover  issues  of  small  size.  A 
foreign  government  loan  of  as  much  as  $6,000,000  was  recently 
"swallowed" — to  use  the  bankers'  own  term — by  a  single  bank- 
ing house ;  but  ordinarily  only  issues  of  less  than  $2,000,000  to 
$3,000,000  are  taken  up  by  an  individual  house. 

Usually,  however,  the  original  agreement  is  made  between 
the  corporation  and  a  single  banking  house,  and  the  banking 
house  afterwards  distributes  proportions  of  the  risk  and  profits 
among  other  banking  houses.  All  these  houses,  working 
together,  thus  form  themselves  into  th^  underwriting  syndicate. 
Most  of  the  larger  banks  and  financial  houses  in  the  chief 
centres  make  it  their  practice  to  work  in  harmony  with  each 
other.  The  organization  of  the  syndicate  and  the  terms  of  the 
syndicate  agreement  will  be  taken  up  a  little  later. 

There  are  two  reasons  which  make  it  preferable  for  a 
banking  house  to  join  a  considerable  number  of  syndicates 
rather  than  to  put  through  a  smaller  number  of  transactions 
in  which  it  assumes  for  itself  all  of  the  risk  and  all  of  the 
profits.  The  first  and  obvious  reason  is  in  order  to  minimize 
risk.  A  false  step  in  a  syndicate — even  though  the  syndicate 
should  fail  ultimately — would  not  prove  ruinous;  whereas  the 
failure  of  a  good-sized  issue  in  which  only  one  house  was 
concerned  might  not  only  tie  up  enough  capital  to  wreck  the 
house,  but  might  also  wreck  its  reputation,  which  is  an  asset 
of  even  greater  importance.  The  second  motive  for  preferring 
syndicate  participation  is  that  it  enables  the  bond  and  brokerage 


UNDERWRITING  343 

houses  to  offer  to  their  customers  a  well-diversified  list  of 
securities.  The  general  retail  security  merchant  should  be 
prepared  to  deliver  to  a  customer  any  kind  of  security  the 
customer  may  fancy,  just  as  the  department  store  is  ready  to 
sell  anything  from  pins  to  locomotives. 

Community  of  Interest  Among  Underwriting  Houses 

If  one  banking  house  closes  a  good  contract  with  an  excel- 
lent chance  of  profits,  others  are  usually  invited  to  come  in  as 
members  of  the  underwriting  syndicate  to  handle  the  contract. 
In  this  way  all  of  them  more  or  less  take  part  in  all  the 
important  underwritings.  There  is,  of  course,  no  formal 
agreement  to  this  effect  but  it  is  tacitly  understood  that  when 
one  house  permits  its  neighbor  and  rival  to  join  in  a  profitable 
underwriting,  the  favor  is  to  be  returned  at  the  first  opportu- 
nity. So  well-understood  is  this  arrangement,  that  frequently 
— in  the  Wall  Street  district  at  least,  and  probably  in  other 
centres — the  firms  which  become  members  of  an  underwriting 
syndicate  are  scarcely  consulted.  The  banking  house  which  has 
made  the  agreement  with  the  corporation  and  which  is  man- 
aging the  syndicate,  simply  distributes  the  issue  as  it  thinks 
best  and  notifies  each  of  the  participants  making  up  the  syndi- 
cate. Most  of  these  somewhat  peremptory  invitations  are 
profitable,  and  it  is  safe  to  say  that  invitations  of  this  kind  from 
one  of  the  three  or  four  most  important  banking  houses  are 
seldom,  if  ever,  refused.  In  testifying  during  the  insurance 
investigation  some  years  ago,  J.  P.  Morgan,  the  elder,  ex- 
plained that  some  highly  important  syndicates  involving  tens 
of  millions  of  dollars  were  organized  by  his  firm  through  the 
simple  process  ^f  calling  up  the  selected  list  of  participating 
houses  on  the  telephone  and  advising  how  much  each  was  ex- 
pected to  subscribe. 

An  important  result  of  this  "community  of  interest"  ar- 
rangement is  that  it  removes  the  occasion  for  keen  competition 


344  SECURING   CAPITAL 

among  the  leading  banking  houses.  It  is  comparatively  of 
minor  importance  whether  one  house  or  another  carries 
through  the  negotiations  with  the  issuing  corporation  and 
becomes  the  active  manager  of  the  syndicate,  because  in  any 
case  each  of  the  important  houses  will  participate  in  the  syndi- 
cate and  in  a  fair  share  of  the  profits. 

In  New  York  it  is  well  understood  that  negotiations  for 
the  flotation  of  an  issue  of  any  size  should  be  taken  up  with 
only  one  of  the  important  banking  houses  at  a  time.  In  case 
negotiations  with  one  house  fail  definitely,  they  may  possibly 
be  taken  up  with  another  house.  But  the  important  banking 
houses  will  not  directly  compete  with  each  other ;  nor  will  one 
of  them  even  interfere  with  suggestions  or  investigations  while 
another  has  the  matter  in  hand.  No  doubt  much  the  same  kind 
of  a  tacit  understanding  exists  in  most  financial  centres.  Many 
business  men  who  are  accustomed  to  dealing  under  highly 
competitive  conditions  resent  the  existence  of  this  invisible 
and  indefinite  bond  union  among  the  large  underwriting 
houses.  If  they  are  bringing  an  issue  into  the  market  to  W. 
sold,  naturally  they  would  like  to  have  it  eagerly  bid  for. 
They  are  looking  for  competition  and  they  find  a  silent,  but 
inflexible,  understanding.  Much  of  the  outcry  of  the  last  few 
years  against  the  so-called  ''money  trust"  is  an  expression  of 
this  resentment. 

The  bankers,  on  the  other  side,  claim  first  of  all  that  un- 
checked competition  would  be  disastrous  not  only  to  them, 
but  also  to  the  whole  business  community  which  they  serve. 
It  would  invariably  mean  reckless  extension  of  credit,  over- 
financing,  and  disregard  of  conservative  principles.  They 
advance  the  claim,  further,  that  they  make  no  oppressive  terms 
or  restrictions  and  that  the  present  situation  leaves  room  for 
difference  of  opinion,  thus  preventing  the  establishment  of  a 
complete  monopoly.  Finally,  they  assert  that  the  relations 
between  the  financial  managers  of  a  corporation  and  the  bank- 


UNDERWRITING 


345 


ing  house  which  handles  the  security  issue  ought  to  be  of 
intimate,  permanent,  and  semi-professional  nature.  A  cor- 
porate official  ought  to  pick  out  a  banker  in  whom  he  has 
implicit  confidence,  just  as  he  picks  out  a  physician  or  a  lawyer 
in  whom  he  has  confidence,  and  ought  to  stick  to  the  man 
or  the  firm  he  has  picked  out  until  that  confidence  is  shaken  or 
there  is  some  real  reason  for  disagreement.  In  that  case,  he 
should  cut  off  all  relations  as  quickly  as  possible  and  entrust 
his  financial  affairs  to  some  other  banking  house.  In  other 
words,  the  banker  feels  that  he  is  rendering  a  personal  and 
partly  professional  service  rather  than  merely  buying  and  re- 
selling a  certain  commodity. 

Syndicate  Agreements 

There  are  four  distinct  types  of  agreements  between  an 
underwriting  syndicate  and  the  corporation  which  puts  out  the 
underwritten  issue.  Possibly  other  variations  from  these  basic 
types  could  be  found. 

1.  The  corporation  may  itself  sell  the  issue  and  the  syn- 
dicate may  simply  insure  that  the  whole  issue  will  be  disposed 
of  within  a  given  time  at  a  minimum  price.  The  corporation, 
we  will  say,  is  bringing  out  an  issue  of  $1,000,000  6%  bonds, 
which  it  offers  at  par.  The  .underwriting  syndicate  may  agree 
that  it  will  take  any  bonds  left  unsold  at  the  end  of  the  year 
at  a  special  price  of  90.  The  syndicate  would  receive  a  com- 
mission of  2  to  5%  for  making  this  agreement.  If  the  issue 
were  successfully  sold,  the  syndicate  would  merely  collect  and 
distribute  its  commission  and  dissolve.  If  the  issue  at  the 
agreed  price  were  unsuccessful,  the  syndicate  would  take  over 
the  unsold  balance  and  dispose  of  it.  This  type  of  agree- 
ment is  now  uncommon  except  when  a  corporation  has  given 
a  subscription  privilege  to  its  own  shareholders  but  is  appre- 
hensive that  the  offer  will  not  be  taken  up  in  full. 

2.  A  banking  house  may  conclude  an  arrangement  with  a 


346  SECURING   CAPITAL 

corporation  to  handle  the  sale  of  a  block  of  securities  and  may 
afterward  call  in  other  banking  houses  to  take  over  certain 
proportions  of  the  risk  and  of  the  profits.  The  corporation, 
however,  has  no  dealings  with  the  syndicate,  as  such,  but  only 
with  the  original  underwriter  which  becomes  the  manager  of 
the  syndicate. 

3.  The  syndicate  may  be  formed  before  a  final  agreement 
with  the  corporation  is  signed,  and  the  agreement  may  be 
directly  between  the  corporation  and  the  syndicate,  though  the 
management  of  the  whole  transaction  and  the  actual  selling 
of  the  securities  may  be  left  in  the  hands  of  the  one  banking 
house  which  has  taken  the  initiative.  This  banking  house 
carries  through  the  sale  of  securities  and  does  not  distribute 
them  to  the  other  members  of  the  syndicate  unless  the  sale 
is  in  whole  or  in  part  unsuccessful. 

4.  The  agreement  is  made  between  the  syndicate  as  a 
whole  and  the  issuing  corporation  and  the  securities  are  at 
once  distributed  among  the  members  of  the  syndicate  in  pro- 
portion to  their  participations.  This  form  of  underwriting  is 
almost  in  the  nature  of  a  joint  purchase,  each  of  the  banking 
houses  being  expected  to  act  independently  in  disposing  of 
its  proportion  of  the  issue.  This  is  perhaps  the  most  common 
and  most  useful  type  of  agreement  for  handling  large  issues. 

It  is  clear,  from  the  brief  descriptions  above  given  that  the 
term  ^'underwriting"  is  used  in  a  loose  sense.  It  is,  in  fact, 
often  difficult  to  distinguish  in  practice  between  underwriting 
a  block  of  securities  and  purchasing  a  block  of  securities. 
Even  when  a  single  banking  hguse  takes  over  outright  the 
complete  security  issue  and  pays  to  the  corporation  the  agreed 
price  for  this  issue,  the  transaction  is  commonly  referred  to 
as  "underwriting." 

Whatever  the  type  of  syndicate  issue  may  be,  there  is  al- 
ways this  common  characteristic :  that  the  active  management 
is  unreservedly  in  the  hands  of  the  banking  house  which 


UNDERWRITING  347 

organized  the  syndicate.  In  the  published  agreement,  for 
example,  of  the  syndicate  which  underwrote  the  retirement 
of  United  States  Steel  Corporation  preferred  stock  in  1902, 
it  is  provided  that : 

J.  P.  Morgan  and  Company  shall  be  sole  managers 
of  the  syndicate,  and  in  behalf  of  the  syndicate  they 
may  make  any  and  all  arrangements,  and  may  perform 
any  and  all  acts,  even  though  not  herein  provided  for,  in 
their  opinion  necessary  or  expedient  to  carrying  out 
the  provisions  of  this  agreement;  or  to  promote  or  to 
protect  what  they  deem  to  be  the  best  interests  of  the 
syndicate.  The  enumeration  of  specific  powers  in  this 
or  any  other  article  of  this  agreement,  shall  not  be 
construed  as  in  any  way  abridging  the  general  powers 
of  this  article  intended  to  be  conferred  upon  or  reserved 
to  J.  P.  Morgan  and  Company. 

Throughout  the  agreement  other  reservations  of  the  same 
general  character  abound,  and  in  this  respect  the  contract  is 
typical  of  most  underwriting  syndicate  agreements. 

In  return  for  its  special  efforts  the  managing  house  usually 
receives  a  commission  as  manager,  which  is  deducted  from 
the  syndicate  profits  before  distribution  of  the  remaining 
profits  is  made  among  all  the  members  of  the  syndicate.  This 
payment  to  the  managing  house  varies  a  great  deal,  depending 
on  the  profitableness  of  the  transaction.  It  will  probably 
average  i  to  2%  on  the  par  value  of  the  block  of  securities. 

It  is  very  rarely  the  case  that  these  syndicate  agreements, 
no  matter  how  informal  they  may  be,  give  rise  to  serious 
misunderstanding  or  litigation.  This  is,  no  doubt,  due  primarily 
to  the  high  standards  of  commercial  honor  which  prevail 
among  the  bankers  who  are  active  in  underwriting  syndicates. 
One  of  the  rare  instances  of  litigation  arose  in  connection  with 
the  syndicate  formed  to  underwrite  the  bonds  issued  at  the 
organization  of  the  Mount  Vernon- Woodberry  Cotton  Duck 
Company.     This  syndicate  was  managed  by  the  Continental 


348 


SECURING   CAPITAL 


Trust  Company  of  Baltimore.  Two  New  York  banks,  the 
Merchants  Trust  Company  and  the  Central  National  Bank, 
each  of  which  had  subscribed  $300,000,  sued  the  Continental 
Trust  Company  in  the  United  States  District  Court  for  the 
return  of  their  subscription.  They  alleged  fraud  and  mis- 
statements. They  claimed  that  the  mills  were  not  worth  what 
they  were  represented  to  be  and  were  not  earning  what  had 
been  stated;  further,  they  claimed  that  the  Continental  Trust 
Company,  through  its  ownership  of  $1,000,000  of  income 
bonds,  had  been  especially  favored  under  the  terms  of  exchange 
that  had  been  agreed  to  in  forming  the  combination.  The 
case  was  never  brought  to  trial  and  was  finally  settled  out  of 
court.* 

The  commissions  of  underwriting  syndicates  may  vary  all 
the  way  from  i^%  to  10%,  or  even  more.  If  the  com- 
missions are  high,  it  is  quite  the  custom  to  make  them  payable 
partly  in  securities.  In  1910,  for  example,  the  newly  organized 
International  Cotton  Mills  Corporation  was  in  need  of  working 
capital,  which  it  secured  by  selling  to  Blair  and  Company 
$2,000,000  6%  five-year  notes  at  par,  in  consideration  of  a 
commission  of  $1,000,000  par  value  of  the  corporation's  com- 
mon stock.  These  notes  were  offered  to  the  public  by  Blair 
and  Company  at  98.  In  1898  the  Union  Pacific  Railroad 
Company  paid  a  syndicate  $5,000,000  of  preferred  stock,  then 
quoted  at  59,  for  underwriting  a  subscribed  capital  of  $15,000,- 
000.  This  amounted  to  a  commission  of  I9%.t  These 
examples,  of  course,  refer  to  companies  which  at  the  time  did 
not  have  a  high  credit  standing,  and  are  not  to  be  taken  as 
typical. 

Speculative  Underwriting 

Most  of  the  preceding  remarks  in  this  chapter  refer  to 
the    underwriting   of   high-grade   bond    and    preferred    stock 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  p.  350. 
fStuart  Daggett's  "Railroad  Reorganizations,"  pp.  347,  348. 


UNDERWRITING  349 

issues  by  financial  houses  of  the  highest  standing.  However, 
this  is  by  no  means  the  only  situation  in  which  underwriting 
is  frequently  advisable.  In  addition  to  assuring  success  in 
disposing  of  large  blocks  of  securities  for  established 
corporations,  syndicates  may  be  formed  for  the  purpose  of 
underwriting  the  issues  of  new  or  of  reorganized  corporations. 

In  any  of  these  three  cases  the  issue  that  is  being  brought 
out  may  be  of  a  speculative  character  and  the  syndicate  itself 
may  be  far  less  stable  and  more  speculative  than  has  been 
assumed  in  what  has  been  said  above.  Frequently  underwrit- 
ing syndicates  are  made  up,  not  of  first-class  banks  or  banking 
houses,  but  in  whole  or  in  part  of  individuals  and  of  second- 
rate  houses.  Sometimes  even  the  best  houses  are  led  into 
mistakes  which  may  cause  financial  loss  and  in  addition  prove 
harmful  to  their  reputation. 

At  the  time  the  United  States  Realty  and  Construction 
Company  was  organized,  the  large  working  capital  which  was 
thought  to  be  necessary  for  the  company  was  obtained  through 
a  syndicate.  $11,000,000  was  subscribed  to  this  syndicate. 
The  members  paid  in  20%  of  their  subscription  in  cash,  gave 
their  notes  for  60%,  and  the  bank  advanced  the  remaining 
20%  on  the  syndicate  account.  The  syndicate  received  $100 
in  preferred  stock  and  $100  in  common  stock  for  each  $100 
in  cash  which  it  furnished.  The  subscribers  included  some  of 
the  strongest  concerns  in  New  York.  The  managers  received 
as  their  compensation  $220,000,  or  2%  of  the  subscriptions  to 
the  syndicate. 

On  the  basis  of  the  first  quotations  for  the  shares  of  the 
United  States  Realty  and  Construction  Company,  the  syndicate 
had  a  paper  profit  of  a  little  less  than  one  million  dollars. 
Although  the  company  had  the  support  of  the  strongest  in- 
terests, its  securities  immediately  began  to  decline  in  market 
value  and  by  the  end  of  six  months  it  still  had  on  hand  a  large 
proportion  of  preferred  and  common  stocks  which  it  had  re- 


350 


SECURING   CAPITAL 


ceived  and  which,  at  current  quotations,  could  be  sold  only  at 
a  heavy  loss. 

On  September  ii,  1903,  the  syndicate  was  dissolved.  The 
managers  of  the  syndicate  had  originally  acquired  110,000 
shares  of  preferred  and  110,000  shares  of  common.  Soon 
after  organization  the  managers  sold  67,000  shares  of  common 
at  $37.50  and  refused  an  offer  of  $35  a  share  for  the  remaining 
43,000  shares.  They  used  a  large  part  of  the  proceeds  in 
purchasing  27,000  shares  of  common  and  17,000  shares  of 
preferred  at  prices  much  less  than  they  had  originally  paid. 

At  its  dissolution,  after  the  managers  had  taken  $220,000 
for  their  services,  the  syndicate  was  in  possession  of  127,000 
shares  of  preferred,  77,000  shares  of  common,  and  $675,000 
in  cash.  Approximately  $500,000  of  the  cash  had  been  re- 
ceived from  dividends  on  the  preferred  stock.  On  the  date 
of  dissolution  the  preferred  stock  was  quoted  at  $36  a  share 
and  the  common  stock  at  $6.50  a  share.  Each  member  of 
the  syndicate  received  for  each  $1,000  contributed,  $1,155  i" 
preferred  stock,  $702  in  common  stock,  and  $61.66  in  money, 
of  which  $45  was  furnished  by  dividends  on  the  preferred 
stock  held  by  the  syndicate.  Eliminating  this  $45,  and  figuring 
the  shares  at  their  market  values,  each  member  of  the  syndicate 
got  back  less  than  one-half  of  the  amount  he  had  contributed. 
Furthermore,  a  week  after  the  dissolution  of  the  syndicate, 
the  fourth  dividend  on  the  preferred  stock  was  passed  and  the 
stock  went  to  yet  lower  levels.* 

Dewing  cites,  also,  another  instance  of  even  more  disas- 
trous failure.  At  the  time  of  the  incorporation  of  the  United 
States  Shipbuilding  Company  in  1902,  the  promoters  were 
required  to  sell  enough  first  mortgage  bonds  between  June  14 
and  August  11  to  have  in  hand  $7,500,000  cash  by  the  latter 
date.  However,  the  public  offering  of  the  bonds  was  a  failure, 
inasmuch  as  only  $500,000  out  of  the  total  offering  of  $9,000,- 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.  233,  235,  238. 


UNDERWRITING 


351 


000  was  subscribed  for.  The  promoters  therefore  fell  back 
upon  their  French  and  American  underwritings  of  the  bonds. 

Here  ensued  a  very  amusing  correspondence  by  cable  be- 
tween the  promoters  and  the  French  underwriters,  most  of 
whom  were  not  bankers  but  individuals  untrained  in  business 
affairs.  The  Frenchmen  declined  to  meet  their  alleged  ob- 
ligations. They  asserted  that  the  promoter  had  assured  them 
that  their  underwritings  would  never  be  called  and  had  later 
cabled  them  that  the  public  offering  of  the  bonds  was  a  success. 

The  American  underwriters,  who  were  better  accustomed 
to  such  transactions,  took  their  medicine  and  accepted  about 
$4,500,000  of  the  bonds  at  90.  The  promoter,  John  W. 
Young,  went  to  Paris  in  a  strenuous  but  unavailing  attempt 
to  secure  payment  from  the  French  underwriters. 

In  the  meantime,  Mr.  Dresser  negotiated,  with  the  as- 
sistance of  Mr.  Schwab  and  J.  P.  Morgan  and  Company,  loans 
of  about  $2,500,000  under  personal  indorsement  of  himself 
and  Mr.  Nixon,  on  the  credit  of  the  Trust  Company  of  the 
Republic,  and  on  the  basis  of  the  French  underwriting.  When 
the  French  underwriters  still  refused  to  take  up  their  share 
of  the  bonds,  the  results  were  disastrous  for  the  promoters.* 

Still  another  example  is  illuminating.  In  19 10  it  became 
evident  that  the  Consolidated  Cotton  Duck  Company  was  in 
need  of  a  considerable  amount  of  new  capital,  both  for  the 
acquisition  of  additional  properties  and  for  investment  in  its 
own  mills.  It  was  determined  that  it  would  be  advisable  to 
secure  a  majority  of  the  stock  for  a  group  of  Bostonians,  who 
desired  to  become  active  in  the  company.  Three  syndicates 
were  formed  as  follows : 

May  27,  1910,  in  order  to  acquire  53%  of  the  Consoli- 
dated Company's  stock  and  a  supply  of  between  two 
million  and  three  million  dollars  working  capital. 


*Dewing*s  "Corporate  Promotions  and  Reorganizations,"  pp.  489,  490. 


352  SECURING   CAPITAL 

April  17,  19 II,  in  order  to  purchase  common  stock  only 

of  the  new  company. 
April  2.J,  191 1,  to  acquire  a  minority  of  Consolidated 

stock  and  supply  $500,000  new  money. 

On  May  27,  19 10,  Augustus  P.  Loring,  a  Boston  lawyer, 
and  Joseph  B.  Crocker,  a  stock  broker,  were  made  syndicate 
managers.  Each  man  received  $12,500  in  compensation  for  his 
services,  in  addition  to  which  Mr.  Loring  received  a  fee  for 
his  legal  services  in  connection  with  the  incorporation  of  the 
new  company.  Much  of  the  work  of  organizing  the  syndi- 
cate and  of  carrying  through  the  reorganization  of  the  com- 
pany was  taken  care  of  by  Samuel  Untermyer,  who  also  used 
his  influence  to  secure  banking  connections  for  the  company. 

The  syndicate  agreement  of  May  27,  which  was  marked 
"confidential,"  contained  the  following  provisions: 

1.  The  new  International  Company  was  to  issue  52,875 

shares  of  preferred  and  45,375  shares  of  common 
to  the  managers  of  the  syndicate. 

2.  The  syndicate  was  to  acquire  61,000  shares  of  pre- 

ferred and  71,000  shares  of  common  of  the  Con- 
solidated Cotton  Duck  Company  ($50  par  value). 

3.  The  syndicate  was  to  purchase  the  preferred  and  com- 

mon stock  of  the  International  for  $5,093,000,  which 
the  subscribers  were  to  take  in  the  proportion  of 
ten  shares  of  preferred  and  ten  shares  of  com- 
mon, for  each  $1,000  of  their  subscription. 

4.  The  managers  were  authorized  to  sell  the  excess  of 

1,945  of  preferred  stock  and  to  purchase  enough 
common  stock  to  make  their  holdings  of  both 
kinds  of  stock  50,930  shares. 

The  Loring-Crocker  syndicate  of  the  International  Cot- 
ton Mills  Corporation  was  unfortunate  in  its  operation.    Syn- 


UNDERWRITING  353 

dicate  subscribers  were  allotted  $100  in  preferred  and  $100 
in  common  stock,  for  each  $100  cash.  Three  years  later, 
in  the  reorganization,  the  old  preferred  stock  was  given  %yy 
in  new  common  stock  of  the  new  International,  and  the  old 
common  stock  was  given  $16.33  i^  ^^^  common.  For  each 
$100  cash  put  in  by  a  syndicate  subscriber,  therefore,  he 
received,  in  191 3,  $93,33  in  new  common  stock,  worth  about 
$30  a  share  on  the  open  market.  For  each  $100  put  in,  the 
syndicate  subscriber  received  after  three  years  $28.  This 
was  not  due  to  failure  of  the  company  but  rather  to  mis- 
calculation at  the  beginning  as  to  the  amount  of  fresh  capital 
that  would  be  required  in  order  to  rehabilitate  the  property 
of  the  company.  * 

It  would  be  difficult  to  give  any  detailed  information  con- 
cerning the  inner  workings  of  these  speculative  syndicates. 
Their  operations  have  not  been  in  any  sense  standardized. 
Each  syndicate  formed  for  speculative  purposes  drives  its 
own  bargain.  Inasmuch  as  its  compensation  ordinarily  comes 
in  the  form  of  securities  rather  than  of  cash  commission, 
its  risk  is  large  and  it  is  generally  entitled  to  a  correspond- 
ingly large  block  of  stock.  The  operations  of  a  syndicate  of 
this  character  in  connection  with  the  promotion  of  a  new  cor- 
poration are  really  a  part  of  the  work  of  promotion  and  have 
been  referred  to  under  that  head.  We  shall  have  occasion  in 
a  later  chapter  to  refer  to  the  activities  of  underwriting  syn- 
dicates in  connection  with  reorganizations. 


*Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.  382,  403. 


Part  IV — Internal  Financial  Management 


CHAPTER    XVI 

INVESTMENT    OF    CAPITAL    FUNDS 

Estimating  Capital  Requirements 

Having  organized  a  corporation,  issued  the  proper  se- 
curities, carried  through  the  process  of  promotion,  and 
disposed  of  the  securities,  what  is  to  be  done  with  the  capital 
that  has  thus  been  secured? 

Presumably  this  question  will  have  been  answered  before 
the  financial  plan  was  formulated ;  that  is  to  say,  the  amount 
of  capital  that  would  be  required  was  first  of  all  estimated  and 
the  financial  plan  was  made  to  fit  this  estimate.  Right  here 
is  a  frequent  source  of  serious  error.  The  capital  required  is 
often  not  estimated  at  its  proper  amount.  It  is  easy  enough, 
usually,  to  calculate  what  will  be  needed  for  plant  and 
machinery,  road-bed  and  equipment,  office  furniture,  or  what- 
ever the  fixed  assets  of  the  business  may  be.  In  addition, 
however,  there  are  two  requirements  of  uncertain  amount 
— for  working  capital  and  development  expenses. 

Sufficient  working  capital  must  be  provided  in  order  to 
take  care  of  the  normal  process  of  purchasing  raw  materials 
and  supplies,  turning  out  finished  products,  selling  the 
products,  and  waiting  for  payments  to  be  made.  If  the 
original  estimates  of  working  capital  are  insufficient,  some 
emergency  measures  must  be  resorted  to  or  the  business  will 
come  to  a  dead  stop. 

The  losses  and  expenses  of  development  are  generally 
underestimated.    Every  new  organization  must  be  in  part  an 

355 


356  INTERNAL    FINANCIAL   MANAGEMENT    • 

experiment.  Men  will  be  employed  who  are  unsuited  for  their 
positions ;  methods  of  production  and  of  sale  will  be  tried  that 
must  be  discarded;  machinery  will  be  installed  that  proves 
worthless;  advertisements  and  sales  booklets  will  be  written 
that  do  harm  rather  than  good.  If  the  enterprise  is  basically 
sound,  all  these  expensive  losses  may  properly  be  charged  as 
a  part  of  the  initial  expense  of  getting  the  business  on  its  feet. 
The  experience  of  generations  has  proved  that  mistakes  of 
this  kind  are  unavoidable  and  they  should  be  provided  for  in 
the  original  estimates  of  capital  expenditures. 

These  remarks  apply — though  with  somewhat  less  force — 
to  the  planning  of  extensions  and  betterments  for  which  fresh 
capital  is  raised.  It  is  an  every-day  occurrence  for  a  manu- 
facturer to  plan  to  put  up  a  new  building  and  install  new 
machinery  that  will  increase  his  capacity,  let  us  say,  50%,  and 
to  overlook  entirely  the  necessity  for  a  corresponding  50% 
increase  in  his  working  capital.  Also,  he  frequently  overlooks 
the  probability  of  experiments  and  losses  in  construction  of 
the  plant  and  in  developing  the  sales  and  administrative  or- 
ganization which  will  take  care  of  the  increased  output. 

Fixed  Capital  and  Working  Capital 

The  distinction  between  fixed  capital  and  working  capital 
is  often  not  clearly  understood.  There  would  be  much  less 
confusion  if  it  were  possible  to  drop  the  adjective  "working," 
which  in  this  connection  is  meaningless,  and  substitute  the 
word  "revolving."  "Fixed"  capital  and  "revolving"  capital 
are  almost  self-explanatory.  The  "fixed"  capital  is  invested 
in  the  plant,  equipment,  and  other  forms  which  cannot  be  dis- 
posed of  without  breaking  up  the  business.  The  "revolving" 
capital  is  invested  in  raw  materials,  in  stocks  of  partly  finished 
and  finished  products,  in  accounts  receivable,  in  salable 
securities,  and  in  cash.  Capital  in  all  these  forms  is  constantly 
being    converted — after    whatever    alterations    in    form    are 


INVESTMENT   OF   CAPITAL   FUNDS  357 

necessary — into  cash,  and  this  cash  flows  out  again  in  exchange 
for  other  forms  of  working  capital.  Thus,  it  is  constantly  re- 
volving; or,  to  use  a  more  common  expression,  it  is  being 
"turned  over." 

Note  that  it  is  said  in  the  preceding  paragraph  that  the 
working  capital  is  invested  in  cash  or  in  various  forms  of 
assets  that  are  readily  convertible  into  cash.  This  is  not 
equivalent,  however,  to  saying  that  the  total  value  of  the  cash 
or  cashable  assets  measures  the  amount  of  the  working  capital. 
On  the  other  side  of  the  balance  sheet,  there  is  a  group  of 
liabilities,  consisting  chiefly  of  short-time  bank  loans  and 
accounts  payable,  which  must  be  deducted  from  the  total  of 
the  working  assets  in  order  to  determine  the  net  working 
capital.  If  this  were  not  done,  a  firm  which  had  managed 
to  pile  up  a  great  quantity  of  merchandise  debts,  might  be 
considered,  looking  only  at  its  assets,  to  be  well  provided  with 
working  capital ;  yet  the  truth  might  be  that  it  had  little  or  no 
surplus  of  working  capital  above  its  current  liabilities. 

Mention  is  frequently  made  of  "quick  assets"  and  "quick 
liabilities,"  and  the  question  is  sometimes  raised  as  to  the 
distinction  between  them  and  "working"  or  "current"  assets 
and  liabilities.  As  a  matter  of  fact,  there  is  no  clear-cut  or 
authoritative  distinction.  In  a  general  sense,  however,  the  ad- 
jective "quick,"  used  in  this  connection,  is  reserved  for  assets 
or  liabilities  that  have  only  a  short  period — say  30  days  or 
less — to  run.  A  stock  of  finished  products  which  are  regarded 
as  immediately  salable  might  be  listed  as  a  quick  asset,  whereas 
a  stock  of  half-finished  products  or  of  raw  materials  could  not 
be  described  as  more  than  a  "working"  or  "current"  asset. 

Necessity  for  Adequate  Working  Capital 

The  history  of  the  Westinghouse  Electric  and  Manufactur- 
ing Company  offers  some  of  the  clearest  and  most  striking 
illustrations  of  the  necessity  of  using  care  in  the  investment 


358  INTERNAL   FINANCIAL   MANAGEMENT 

of  capital  funds,  and  especially  of  the  advisability  of  keeping 
on  hand  an  ample  supply  of  working  capital.  The  illustrations 
are  especially  apt,  because  this  company  has  always  carried 
on  an  extensive  and  profitable  business  and,  so  far  as  industrial 
processes  go,  has  been  conspicuously  well  managed.  Yet  it 
became  financially  embarrassed  in  1890,  and  again  in  1907, 
both  embarrassments  being  the  direct  result  of  rapid  expansion 
of  business,  leading  to  a  large  investment  in  fixed  assets  and 
a  relative  diminution  of  working  assets. 

When  it  was  realized  by  the  of^cers  of  the  company  in 
1890,  that  the  steady  growth  of  the  business  was  leading  to 
a  dangerous  financial  situation  and  larger  and  larger  current 
obligations  which  could  not  be  met  were  piling  up,  it  was 
decided,  as  an  emergency  measure  to  increase  the  stock  from 
$5,000,000  to  $10,000,000  and  to  offer  the  additional  $5,000,- 
000  to  previous  shareholders  at  the  bargain  price  of  $40  a 
share.  Radical  proposals  of  this  kind,  being  obviously  in- 
tended to  relieve  pressing  demands,  naturally  arouse  distrust. 
The  net  amount  realized  by  the  company  from  this  sale  was 
only  about  $1,400,000,  which  was  not  enough  to  create  an 
adequate  working  capital.  In  fact,  the  situation  rapidly  be- 
came worse.  In  the  summer  of  1890  the  company  had 
outstanding  about  $2,000,000  of  notes  covering  merchandise 
purchases  and  bank  loans.  By  the  early  part  of  1891  the 
floating  debt  had  become  $3,300,000.  A  financial  reorganiza- 
tion, with  its  attendant  frictions  and  losses^  was  then  recognized 
as  inevitable. 

After  the  reorganization  of  1891  the  company  continued 
to  expand  its  business  and  as  a  result  continued  to  meet  serious 
financial  problems.  These  problems  were  not  wholly  the  out- 
growth of  internal  development,  but  were  in  part  a  necessary 
feature  of  the  electrical  industry  as  a  whole.  The  progress 
of  electrical  invention  required  continual  and  extensive  in- 
vestment of  capital  for  generating  stations,  transmission  lines, 


INVESTMENT   OF   CAPITAL   FUNDS 


359 


and  electrical  machinery.  Throughout  the  country  small 
lighting,  power,  and  traction  companies  were  endeavoring  to 
sell  their  securities,  frequently  without  much  success.  Yet, 
it  was  evident  that  their  projects  in  most  cases  were  sound 
and  it  seemed  to  be  necessary  for  the  Westinghouse  Company, 
in  order  to  keep  up  and  develop  its  sales,  to  assume  a  portion 
of  the  burden  of  financing  its  customers.  This  it  did  by  ac- 
cepting in  payment  for  equipment  the  notes  of  these  local 
companies,  generally  secured  by  a  deposit  of  their  bonds  and 
stocks  as  collateral.  The  Westinghouse  Company  then  relied 
on  discounting  these  notes,  which  in  normal  times  could 
readily  be  arranged  for.  At  periods  of  credit  restriction, 
however,  the  notes  became  unmarketable  and  the  Westing- 
house Company  itself  was  hard  pressed  for  funds  with  which 
to  meet  its  own  obligations. 

Between  1891  and  1907,  this  growing  problem  was  success- 
fully solved  by  repeated  sales  of  capital  stock.  In  1896  the 
authorized  capital  was  increased  from  $10,000,000  to  $15,- 
000,000,  and  in  1901  from  $15,000,000  to  $25,000,000.  At 
the  same  time,  the  company  was  putting  out  several  million 
dollars  of  collateral  and  debenture  bonds.  Nevertheless,  notes 
payable  grew  steadily  until  they  aggregated  $5,000,000  in 
1 90 1,  and  $14,000,000  in  1905. 

Dewing  has  calculated  this  company's  ratio  of  current 
liabilities  to  current  assets,  of  current  assets  to  total  assets, 
and  of  current  liabilities  to  total  liabilities,  for  a  number  of 
years,  as  follows  :* 


Current  Liabili- 
ties   to  Current 
Assets 

Current  Assets 
to  Total 
Assets 

Current  Liabili 
ties  to  Total 
Liabilities 

Feb.    29,  1892 

46% 

12% 

6% 

Mar.  31,  1894 

22% 

34% 

8% 

Mar.  31,  1897 

106% 

11% 

12% 

Mar.  31,  1901 

83% 

25% 

21% 

^Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.   165,  200. 


360              INTERNAL 

FINANCIAL 

,   MANAGEMENT 

Mar.  31,  1902 

71% 

27% 

19% 

Mar.  31,  1903 

88% 

26% 

23% 

Mar.  31,  1904 

101% 

22% 

23% 

Mar.  31,  1905 

163% 

18% 

29% 

Mar.  31,  1906 

66% 

22% 

14% 

Mar.  31,  1907 

96% 

16% 

15% 

Oct.    31,  1907 

86% 

20% 

17% 

When  the  company  was  finally  compelled  in  1907  to  confess 
its  inability  to  meet  current  obligations  and  a  receiver  was 
appointed,  it  was  at  once  agreed  on  all  sides  that  the  prime 
cause  of  the  failure  was  the  lack  of  sufficient  working  capital. 

There  were,  however,  some  differences  of  opinion  as  to  the 
extent  of  the  remedy  that  should  be  applied.  The  creditors 
were  inclined  to  demand  not  only  an  immediate  relief,  but  a 
radical  change  of  financial  policy.  Mr.  Westinghouse,  on  the 
other  hand,  did  not  believe  that  there  was  anything  funda- 
mentally wrong  with  the  previous  financial  policy  of  the  com- 
pany and  sought  only  to  extricate  it  from  its  immediate  en- 
tanglement. It  was  finally  agreed  in  the  interest  of  the  credi- 
tors and  of  all  those  who  were  disposed  to  insist  upon  sound 
financing,  that  a  new  management  should  take  the  reins. 

There  are  not  many  instances  of  large  enterprises  where 
miscalculation  and  recklessness  in  financial  affairs  were  com- 
bined with  so  much  unquestioned  ability  in  handling  mechani- 
cal and  industrial  affairs  as  in  the  case  of  the  Westinghouse 
Company.  Most  large  and  successful  companies  have  a  better- 
balanced  management.  In  small  corporations,  however,  almost 
the  same  situation  is  frequently  found.  The  proprietor  and 
manager  of  a  business,  through  his  personal  energy  and  re- 
sourcefulness, makes  it  move  ahead  and  earn  good  profits. 
To  take  care  of  his  increasing  business  he  extends  his  plant 
or  builds  up  his  store  or  in  some  other  form  enlarges  his 
fixed  capital  investment  and  fixed  expenses.  Thereupon  he 
suddenly  wakes  up  to  the  surprising  fact  that,  on  account 


INVESTMENT   OF    CAPITAL   FUNDS  361 

of  his  prosperity  he  is  pressed  harder  and  harder  for  funds. 
Unless  there  is  a  sudden  change  in  his  methods,  it  is  more 
than  Hkely  that  he  will  drive  rapidly  ahead  into  bankruptcy. 
A  sad  and  constantly  recurring  spectacle  in  business  life  is 
that  of  a  strong  man  beaten  into  failure  through  his  own 
energy  and  ability  in  producing  and  selling. 

Some  Factors  That  Affect  Working  Capital 

How  is  it  possible  to  calculate  in  advance  how  much  work- 
ing capital  will  be  required,  and  thus  keep  on  the  safe  side 
in  providing  capital  funds  ?  It  is  not  possible  to  give  an  exact 
formula  for  answering  this  question,  but  an  approximate  an- 
swer in  any  given  case  may  be  reached. 

First  of  all,  it  is  clear  that  the  proportion  of  working 
capital  in  some  lines  of  business  is  far  greater  than  in  other 
lines.  This  may  be  illustrated  by  two  extreme  cases.  Tele- 
phone companies  necessarily  have  large  sums  invested  in  wir- 
ing, poles,  central  offices,  and  other  equipment,  but  after  a 
complete  telephone  plant  has  been  installed  in  a  community 
the  running  expenses  consist  simply  in  maintenance  and  in  the 
salaries  of  officers  and  employees  and  are  comparatively  light. 
It  is  the  custom  for  telephone  companies  to  render  bills  for 
their  services  once  a  month  in  advance;  consequently,  all  the 
money  which  is  required  for  running  expenses  from  month  to 
month  is  provided  before  the  expenses  are  really  incurred. 
Evidently  there  is  no  necessity  in  this  instance  for  working 
capital,  because  the  current  receipts  may  safely  be  depended 
upon  to  take  care  of  the  current  outgo. 

On  the  other  hand,  let  us  take  a  retail  store  which  occupies 
rented  quarters.  The  only  fixed  assets  required  will  consist 
of  store  furniture  and  equipment ;  all  the  other  assets,  includ- 
ing the  stocks  of  merchandise,  the  accounts  receivable,  and  the 
cash,  are  "current"  or  "working."  The  greater  portion  of  the 
capital  that  must  be  invested  in  such  an  enterprise,  will  consist 


362 


INTERNAL    FINANCIAL   MANAGEMENT 


of  working  capital.  This  is  true  of  practically  all  trading 
enterprises,  and  is  particularly  true  of  financial  enterprises. 
Banks  must  keep  all,  or  nearly  all,  of  their  assets  in  such  a 
form  as  to  be  converted  into  cash  almost  at  a  moment's  notice. 

We  may  consider,  therefore,  as  the  first  factor  which  deter- 
mines the  requirements  of  working  capital,  the  general  nature 
of  the  business.  If  the  business  consists  merely  of  leasing  real 
estate,  providing  facilities  for  transportation,  and  the  like,  all 
or  nearly  all  of  the  investment  will  be  in  fixed  forms.  If  the 
business  is  manufacturing,  then  a  relatively  small  proportion 
will  consist  of  working  capital.  If  it  is  trading  or  financing, 
the  chief  requirement  will  be  for  working  capital. 

A  second  factor  obviously  is  the  volume  of  business.  Gen- 
erally speaking,  the  necessity  for  working  capital — except  in 
the  first  class  of  business  above  mentioned — will  vary  in  pro- 
portion to  the  volume  of  sales.  However,  this  statement  as- 
sumes that  the  other  factors  mentioned  below  are  uniform  in 
their  operation.  Making  the  assumption  that  methods,  ex- 
penses, and  terms  of  buying  and  selling  goods  and  of  produc- 
ing the  goods  are  standardized,  then  we  may  safely  say  that 
a  50%  increase  in  output  and  sales  will  necessitate  a  propor- 
tionate increase  in  working  capital. 

But  these  general  remarks  as  to  the  nature  and  volume  of 
business  are  serviceable  chiefly  in  forestalling  any  misunder- 
standing of  what  follows. 

The  practical  considerations  that  require  thought  and  are 
helpful  in  making  estimates  of  working  capital  are : 

1.  Length  of  period  of  manufacture. 

2.  Turnover. 

3.  Terms  of  sale. 

4.  Terms  of  purchase. 

5.  Facilities  for  converting  working  assets  into  cash. 

6.  Seasonal  variations  in  business. 


INVESTMENT   OF   CAPITAL   FUNDS 


363 


The  process  of  making  proper  allowances  for  all  these 
factors  and  of  calculating  in  advance  the  volume  of  working 
capital  that  will  be  needed  is  of  so  much  importance  that  a 
separate  chapter  is  devoted  to  this  subject  (Chapter  XVII). 

Figuring  Fixed  Capital  Requirements 

It  has  been  noted  above  that  it  is  comparatively  easy  to 
calculate,  before  an  enterprise  is  started,  how  much  of  an 
investment  will  be  required  in  order  to  provide  plant,  machin- 
ery, and  other  fixed  capital.  This  statement  is  true,  assum- 
ing that  the  enterprise  is  simple  and  unified,  and  that  the  pro- 
moters and  managers  know  exactly  what  they  intend  to  do. 

Unfortunately  this  last  condition  does  not  always  exist. 
It  is  a  common  occurrence  to  find  that  a  company  which  was 
started  to  manufacture  a  given  line  of  goods,  gradually  en- 
gages in  the  manufacture  of  something  entirely  different.  Or 
it  may  continue  to  manufacture  a  given  line  but  discover  that 
some  new  process  is  required.  Again,  after  a  company  has 
once  developed  its  own  special  business  successfully,  its  man- 
agers almost  invariably  begin  to  thirst  for  fresh  conquests  and 
begin  to  take  on  "side  lines."  Or,  yet  again,  the  managers 
of  a  company  which  has  proved  successful  may  decide  to 
make  use  of  the  surplus  that  is  accumulating  for  their  own 
purposes  instead  of  distributing  it  to  the  stockholders,  and 
may  build  up  a  large  account  under  the  head  of  "investments." 

In  figuring  the  requirements  for  fixed  capital,  therefore, 
we  have  to  consider  not  only  the  original  plant  and  equipment 
which  must  be  obtained  in  order  to  bring  the  business  into 
existence,  but  also  later  acquisitions  or  developments  along 
any  one  of  the  following  lines : 

1.  Extensions  of  the  original  plant.  ' 

2.  Increases  or  changes  in  equipment. 

3.  Adoption  of  side  lines. 

4.  Outside  investments. 


364  INTERNAL   FINANCIAL   MANAGEMENT 

It  is  in  connection  with  subsequent  changes  or  develop- 
ments along  these  lines  that  most  of  the  opportunities  for 
mistakes  and  miscalculations  in  the  investment  of  capital  in 
fixed  forms  arise. 

Investing  Capital  in  Extensions 

One  of  the  most  curious  instances  on  record  of  a  dis- 
astrous investment  on  the  part  of  a  corporation  in  extending 
its  own  business,  is  that  of  the  Assets  Realization  Company. 
This  company  was  organized  for  the  specific  purpose  of  giving 
financial  relief  to  embarrassed  concerns,  by  taking  over  the 
assets  which  they  could  not  otherwise  dispose  of.  It  is  fre- 
quently possible  to  purchase  from  such  concerns  plants,  ma- 
chinery, securities,  and  other  assets  of  great  value,  at  bargain 
prices.  It  was  the  expectation  of  the  organizers  of  the  Assets 
Realization  Company  that  they  could  take  their  choice  among 
properties  thrown  on  the  market  in  this  way,  and  could  re- 
habilitate them  or  adapt  them  to  other  uses  or  see  to  it  that 
they  were  managed  in  a  more  ef^cient  manner,  and  in  this 
way  realize  large  profits  for  themselves.  The  plan  seemed 
fundamentally  sound,  and  for  some  years  the  Assets  Realiza- 
tion Company  was  successful.  As  it  proceeded,  however,  the 
company  gradually  extended  its  operations  into  the  underwrit- 
ing of  securities  of  new  corporations,  which  for  one  reason  or 
another  could  not  be  marketed.  Furthermore,  it  is  stated  that 
some  of  the  assets  which  had  been  taken  over  from  insolvent 
corporations  could  neither  be  utilized  nor  resold,  and  remained 
as  a  dead  weight  on  their  hands.  Eventually  the  company 
became  afflicted  with  the  same  disease  which  it  had  undertaken 
to  cure,  and  was  itself  so  loaded  down  with  unrealizable  assets 
that  it  was  compelled  in  1914  to  go  into  the  hands  of  receivers. 
It  had  extended  its  business  beyond  the  limits  of  prudence. 

Another  instance  of  unwise  extension  was  the  purchase  by 
the  United  States  Cordage  Company  in  1894,  of  a  binder  twine 


INVESTMENT   OF   CAPITAL   FUNDS  365 

mill  from  the  McCormick  Harvesting  Machinery  Company 
for  $900,000,  of  which  $500,000  was  paid  in  cash.  At  the 
same  time  that  the  company  was  paying  out  $500,000  for  this 
mill,  it  was  borrowing  $500,000  in  order  to  meet  interest 
payments  for  its  funded  debt.  The  new  mill  could  not  at  once 
become  a  dividend  payer,  but  rather  called  for  additional  in- 
vestment. Therefore  it  is  not  surprising  that  within  a  short 
time  the  United  States  Cordage  Company  found  itself  in 
financial  difficulties. 

Shortly  after  the  formation  of  the  Consolidated  Cotton 
Duck  Company  in  1905,  it  was  decided  to  purchase  the  H. 
Spencer  Turner  Company,  which  was  the  chief  selling  agent 
for  the  products  of  the  Consolidated  Company.  The  arrange- 
ment increased  the  funded  debt  of  the  Consolidated  Company 
by  about  $1,500,000,  which  was  its  total  investment  in  this 
extension  of  its  business.  The  chief  assets  of  the  Turner 
Company  consisted  of  its  good-will  and  trade  connections 
acquired  in  handling  the  Consolidated  Company's  own  trade 
marks  and  brands.  Instead  of  assisting  in  the  marketing  of 
the  company's  products,  the  move  really  stimulated  competi- 
tion, inasmuch  as  other  selling  agents,  fearing  that  their  inde- 
pendence might  be  threatened,  began  to  establish  duck  mills 
of  their  own. 

Many  large  corporations  have  been  led  astray  by  the  idea 
that  it  was  necessary  for  them  to  extend  their  business  by 
attempting  to  buy  up  all  competitors.  The  chief  result  has 
been  that  they  have  "held  the  bag"  for  all  kinds  of  trouble- 
making  schemes.  The  contrary  policy  is  ably  set  forth  by 
Chairman  A.  W.  Green  in  the  annual  report  of  the  National 
Biscuit  Company  for  1901.     Mr.  Green  says: 

When  the  Company  started  it  was  believed  that  we 
must  control  competition,  and  to  do  this  we  must  either 
fight  it  or  buy  it.  The  first  meant  ruinous  war  of  prices, 
the  second  constantly  increasing  capitalization.     Experi- 


366 


INTERNAL   FINANCIAL   MANAGEMENT 


ence  soon  proved  to  us  that  instead  of  bringing  success, 
either  of  these  courses,  if  persevered  in,  must  bring 
disaster.  This  led  us  to  ask  ourselves  whether  the  Com- 
pany, to  succeed,  must  not  be  managed  like  any  other 
large  mercantile  business.  We  soon  decided  that  within 
the  Company  itself  we  must  look  for  success. 

We  turned  our  attention  and  bent  our  energies  to  im- 
proving the  internal  management,  to  getting  the  full 
benefit  from  purchasing  our  raw  materials  in  large 
quantities,  to  economizing  the  expense  of  manufacture, 
to  systematizing  our  selling  department,  and  above  all 
things  to  improving  the  quality  of  our  goods.  It  became 
the  settled  policy  of  this  Company  to  buy  out  no  com- 
petition, and  to  that  policy,  since  it  was  adopted,  we  have 
steadfastly  adhered  and  expect  to  adhere  to  the  end. 

Another  very  common  fallacy  on  the  part  of  manufactur- 
ers is  the  notion  that  they  must  handle  their  ov^n  retail  outlets, 
and  to  do  so  must  build  up  a  group  of  chain  stores.  This 
policy  has,  in  fact,  been  successfully  followed  by  many  im- 
portant companies,  such  as  the  George  E.  Keith  Company, 
manufacturers  of  "Walk-Over"  shoes,  the  Regal  Shoe  Com- 
pany, a  great  many  brewing  companies,  etc.  In  practically 
every  such  instance,  however,  it  will  be  found  that  the  policy 
has  been  followed  as  a  means  of  protection,  not  as  a  profit- 
maker  in  itself.  The  dangers  of  extension  along  this  line 
are  not  to  be  minimized.  The  manufacturer,  in  the  first 
place,  is  going  into  a  line  of  business  with  which  he  is  not 
familiar  and  where  it  is  difficult  to  avoid  numerous  pitfalls. 
In  the  second  place,  he  is  likely  to  find  that  the  move  brings 
him  the  active  hostility  of  the  retailers  who  have  previously 
served  as  his  agencies,  thus  making  it  necessary  for  him  to 
develop  his  chain  of  stores  more  rapidly  than  he  had  antic- 
ipated and  to  invest  more  money  than  he  had  counted  upon. 

It  is  a  fact  often  commented  upon  that  successful  corpora- 
tions, as  they  expand,  ordinarily  tend  to  earn  smaller  and 
smaller  returns  on  the  actual  value  of  their  property.     One 


INVESTMENT   OF   CAPITAL   FUNDS 


367 


common  explanation  is  that  at  the  beginning  one  or  two 
managers  exercise  close  personal  supervision  over  the  whole 
enterprise,  and  direct  it  by  their  insight  and  wisdom  into 
the  most  profitable  channels;  whereas  later  their  duties  are 
necessarily  delegated  in  part  to  men  of  less  ability.  The 
economist  offers  in  explanation  the  "Law  of  Diminishing 
Returns/'  which  is  simply  the  principle  that  the  most  advanta- 
geous opportunities  for  utilizing  capital  and  energy  are  taken 
at  the  beginning,  and  the  less  advantageous  opportunities 
are  left  for  future  development.  Yet,  neither  one  of  these 
explanations  applies  in  the  case  of  many  corporations  which 
are  ably  managed  and  which  continually  raise  and  invest  fresh 
capital  without  decreasing  the  average  rate  of  return.  Mod- 
ern methods  of  organization  and  management  and  the  advan- 
tage of  being  able  to  employ  specialized  talent  go  far  toward 
offsetting  the  first  difficulty  above  named.  As  to  the  economic 
principle,  it  applies,  to  be  sure,  but  only  after  the  industry 
has  been  so  far  developed  that  all  its  highly  advantageous 
opportunities  have  been  sought  out  and  utilized;  and  that 
is  a  condition  which  obtains  in  very  few  lines  of  business. 
We  may  safely  infer  that  one  important  cause  for  a  decline 
in  the  rate  of  return  is  to  be  found  in  the  strong  tendency 
to  make  extensions  of  original  businesses  along  lines  that  are 
not  wisely  chosen.  The  results  of  each  move  are  not  fore- 
seen and  calculated  with  sufficient  care. 

As  an  example  of  profitable  extension  on  a  great  scale, 
we  may  take  the  case  of  the  General  Electric  Company.  Dur- 
ing the  nine  years,  1905-1913,  the  capital  stock  increased 
from  $48,000,000  to  $101,000,000.  However,  $23,000,000 
of  this  increase  represented  a  stock  dividend  in  1912  and 
another  $10,000,000  was  due  to  conversion  of  debenture  bonds, 
leaving  only  $20,000,000,  or  slightly  over  40%,  as  an  actual 
increase  of  invested  capital.  During  these  nine  years,  the 
profits  applicable  to  dividends  doubled  and  the  gross  sales 


368 


INTERNAL   FINANCIAL   MANAGEMENT 


nearly  tripled.  All  this  has  been  accomplished  by  steady 
progress  in  extending  the  business  along  lines  that  had  pre- 
viously been  mapped  out.  It  is  an  inspiring  record  of  what 
may  be  accomplished  by  persistent  and  consistent  effort. 

Calculating  the  Extension  of  Capital  for  a  Bank 

The  previous  discussion  in  this  chapter  has  been  related 
chiefly  to  manufacturing  and  trading  establishments.  The 
same  principles,  however,  apply  to  all  lines  of  business.  Not 
long  ago  the  president  of  an  important  national  bank  had 
under  consideration  the  advisability  of  increasing  his  capital 
stock  from  $750,000  to  $1,000,000,  but  an  analysis  of  the 
status  of  his  bank  and  of  customary  practice  in  regard  to 
banking  capital  indicated  that  the  increase  would  be  inad- 
visable for  the  reasons  stated  below. 

The  combined  capital  and  surplus  of  this  bank  was  found 
to  bear  a  relation  to  the  deposit  liabilities  of  about  i  to  4. 
Other  banks  in  the  same  city  varied  from  as  low  as  i  to  3 
to  as  high  as  i  to  5.8.  In  the  City  of  New  York  some  of 
the  large  banks  have  proportions  as  follows: 

American  Exchange  National  Bank i  to  5.5 


First  National  Bank i 

Fourth  National  Bank i 

Hanover  National  Bank i 

Merchants  National  Bank i 

National  Park  Bank i 

National  City  Bank i 

National  Bank  of  Commerce i 


9 

4 

6.6 

6.7 

6.7 

3-7 

4 


Although  some  of  these  banks  have  a  high  proportion, 
it  seems  to  have  been  the  practice  of  at  least  two  of  them 
in  recent  years  to  increase  their  capital  from  time  to  time 
so  that  the  proportion  existing  between  the  capital  and  sur- 
plus on  the  one  side  and  deposit  liabilities  on  the  other  side, 
would  be  about  i  to  4.     This  proportion  is  generally  regarded 


INVESTMENT   OF   CAPITAL    FUNDS 


369 


as  about  correct  for  a  bank  doing  the  ordinary  type  of  com- 
mercial business,  though  there  may,  of  course,  be  excellent 
reasons  for  either  a  higher  or  a  smaller  proportion  in  par- 
ticular cases. 

In  the  case  under  consideration  the  bank  was  said  by  its 
president  to  be  carrying  on  the  ordinary  type  of  commer- 
cial business  and  to  be  earning  reasonably  good  but  not 
extraordinary  profits.  If  a  great  many  new  accounts  were 
to  be  taken  over  and  the  deposit  liabilities  were  thus  to  be 
largely  expanded,  its  present  capital  would  probably  not  be 
enough  to  maintain  a  secondary  reserve  up  to  the  full  re- 
quirements of  safety.  Unless,  and  until,  this  expansion  should 
take  place,  however,  there  seemed  to  be  no  necessary  reason 
for  increasing  the  capital  so  as  to  reduce  the  proportion  of 
capital  to  surplus  liabilities  below  the  normal  ratio. 

There  would  still  remain  the  question  whether  the  increase 
in  capital  at  this  time  would  in  itself  be  a  factor  tending  to 
bring  about  a  corresponding  expansion  of  current  discount 
and  deposit  business.  On  this  point,  the  consensus  of  opinion 
seems  to  be  in  the  negative.  When  the  capital  of  a  bank  is 
not  profitably  occupied  and  is  not  earning  a  normal  rate  of 
profit,  the  directors  and  managers  are  immediately  put  under 
pressure  to  find  employment  for  the  idle  funds.  This  they 
can  accomplish  either  by  making  investments  in  securities  and 
commercial  paper,  apart  from-  the  paper  that  comes  to  them 
from  their  own  customers,  or  by  entering  into  side-line  activi- 
ties, such  as  underwriting  and  the  like.  Neither  course  of 
action  is  advisable  for  a  commercial  bank.  A  third  possible 
course,  which  in  this  case  would  not  be  given  serious  con- 
sideration, is  that  of  soliciting  the  accounts  of  new  and  weak 
depositors. 

On  the  whole,  there  is  probably  no  substitute  in  the  bank- 
ing business  for  the  slow  and  solid  growth  that  naturally 
goes  on  after  a  bank  has  become  well-established  and  is  main- 


370  INTERNAL    FINANCIAL   MANAGEMENT 

taining  an  untarnished  reputation  for  conservatism  mixed 
with  a  reasonable  degree  of  alertness.  Expansion  of  that 
nature  will  gradually  build  up  deposit  liabilities  until  it  be- 
comes advisable  to  make  a  corresponding  increase  in  capital. 
But  the  chief  point  to  bear  in  mind  is  that  the  expansion  will 
come  first  and  the  increase  in  capital  will  appear  as  a  result, 
not  a  cause. 

Investing  Capital  in  Betterments 

One  of  the  frequent  causes  of  embarrassment  to  corpora- 
tions which  take  over  going  concerns,  or  which  are  formed  in 
order  to  combine  previously  existing  concerns,  is  the  discov- 
ery that  the  supposed  net  earnings  of  the  acquired  concern 
have  been  achieved  through  failure  to  maintain  the  prop- 
erty in  first-class  condition.  Of  course,  if  the  investigation 
has  been  sufficiently  thorough,  this  fact  will  presumably  have 
been  discovered.  However,  the  truth  is  that  such  investi- 
gations frequently  are  carried  on  in  slipshod  fashion,  or  may 
even  be  omitted  altogether.  Cases  are  not  uncommon  where 
important  combinations  have  been  formed  on  the  strength 
of  the  unsupported  statements  of  earnings  submitted  by  each 
of  the  constituent  companies. 

When  the  International  Cotton  Mills  Corporation  was 
organized  in  191  o  to  take  over  the  mills  of  the  old  Mount 
Vernon- Woodberry  Company  and  the  Consolidated  Cotton 
Duck  Company,  it  appeared  on  the  surface  that  sufficient 
new  cash  and  working  capital  had  been  provided.  It  devel- 
oped later,  however,  that  the  mills  acquired  were  in  a  dilapi- 
dated condition  and  that  much  larger  sums  than  had  been 
anticipated  were  necessary  in  order  to  rehabilitate  the  prop- 
erty. Due  to  this  weakness,  the  corporation  got  into  difficul- 
ties, and  a  reorganization  became  necessary  in  19 13. 

Even  within  a  going  and  apparently  successful  corporation 
the  same  condition  may  exist.     If  the  direction  of  affairs  is 


INVESTMENT   OF   CAPITAL   FUNDS 


371 


left  wholly  in  the  hands  of  the  active  officers  they  will  not 
be  over-anxious  to  disturb  their  showing  of  profits  by  set- 
ting aside  ample  sums  to  offset  depreciation  and  to  maintain 
the  property  at  its  full  value.  It  must  be  borne  in  mind  that 
making  repairs  from  time  to  time  is  not  enough.  If  com- 
petitors are  installing  new  and  more  efficient  machinery,  it  is 
not  sufficient  for  the  company  to  keep  its  old  machinery  in 
good  repair.  At  some  later  date,  when  the  fact  becomes 
known  that  large  amounts  are  urgently  required  to  bring 
the  property  back  into  first-class  condition,  both  the  stock- 
holders and  the  directors  are  likely  to  be  loath  to  give  up 
or  even  reduce  their  dividends  to  atone  for  the  errors  of 
the  past.  Instead,  the  idea  of  raising  new  capital  to  provide 
•for  betterments  will  meet  with  favor.  It  will  be  argued  that 
betterments  represent  a  capital  expenditure  which  may  prop- 
erly be  provided  through  the  issuance  of  fresh  securities,  but 
the  expenditures  now  accumulated  in  a  lump  should  have  been 
met  out  of  profits  over  a  series  of  years.  It  is  also  probable 
that  fresh  capital  invested  in  bringing  the  plant  and  machin- 
ery up  to  a  reasonable  degree  of  efficiency  will  not  materi- 
ally increase  the  profits,  but  will  merely  have  the  effect  of 
preserving  and  restoring  the  profits  the  concern  has  been 
earning. 

The  question  as  to  when  betterments  constitute  a  legitimate 
capital  expenditure  and  when  they  should  be  met  out  of  earn- 
ings, is  naturally  always  debatable.  Conservative  management 
tends  strongly  to  decide  the  question  in  favor  of  the  second 
alternative.  When  it  is  not  so  decided,  there  is  always  a 
danger  at  least  of  investing  fresh  capital  in  a  form  that  will 
bring  little  if  any  returns.  The  statement  is  so  obvious  that  no 
illustration  is  needed  to  enforce  it.  Its  importance,  however, 
should  not  be  overlooked.  In  connection  with  the  subject  of 
distribution  of  income,  the  question  as  to  the  proper  financing 
of  betterments  will  be  discussed  at  greater  length. 


Z7^ 


INTERNAL   FINANCIAL   MANAGEMENT 


Investing  Capital  in  Side  Lines 

As  has  been  remarked,  the  managers  of  a  corporation  that 
has  proved  successful  are  seldom  willing  to  stop.  They  wish 
to  go  ahead  and  enlarge  their  profits.  This  statement  applies 
notably  to  the  business  men  of  the  United  States.  In  England 
and  other  countries  business  customs  favor  building  up  a  sound 
business  and  maintaining  it  rather  than  restlessly  pushing  into 
other  fields.  No  doubt  the  American  practice  makes  for  pro- 
gressiveness,  yet  it  also  involves  a  constantly  recurring  danger 
of  disaster. 

The  number  of  companies  which  have  taken  on  "side  line" 
enterprises  to  their  sorrow  is  far  beyond  what  would  usually 
be  supposed.  A  conspicuous  example  is  the  American  Loco- 
motive Company  which  some  years  ago  decided  to  engage  in- 
the  business  of  manufacturing  automobiles.  The  plant  was 
poorly  located  and  it  is  to  be  presumed  that  the  officers  had 
neither  the  time  nor  the  special  training  which  would  have 
enabled  them  to  handle  this  business  with  success.  In  191 3 
internal  dissension  in  the  company  brought  to  light  the  fact 
that  over  $2,300,000  had  been  lost  during  that  year  in  the 
automobile  enterprise.  Subsequently  the  directors  decided  to 
accept  their  loss,  dispose  of  the  plant  and  other  assets,  and  close 
all  their  activities  in  this  field. 

In  1 9 14  the  American  Water  Works  Guarantee  Company 
became  financially  embarrassed.  This  company  had  been  a 
highly  successful  promoter  of  public  utility  corporations  and 
of  holding  companies  operating  in  the  public  utility  field. 
After  having  succeeded  in  this  line,  it  attempted  to  carry  out 
certain  irrigation  projects  and  invested  in  these  projects  more 
than  $10,000,000.  In  addition  it  eventually  became  necessary 
for  the  company  to  indorse  more  than  $23,000,000  of  the 
obligations  of  its  irrigation  subsidiaries.  The  result  was  that 
this  "side  line"  became  the  most  important  activity  of  the 
company  and  was  the  direct  cause  of  its  embarrassment. 


INVESTMENT   OF   CAPITAL    FUNDS  373 

On  the  other  hand,  it  is  sometimes  true  that  a  *'side  line" 
may  prove  to  be  the  only  really  profitable  feature  of  a  business. 
For  example,  the  London  Underground  Electric  Railways 
Company  shows  investments  of  a  nominal  value  of  £17,000,- 
000,  of  which  £15,500,000  is  in  the  various  underground 
railway  companies,  and  £1,500,000  is  in  the  London  General 
Omnibus  Company.  The  profits  from  the  underground  rail- 
ways were  a  trifle  over  1%,  or  about  £160,800;  the  profits 
from  the  omnibus  service  were  nearly  23%,  or  approximately 
£377,000. 

Some  of  the  great  meat-packing  concerns  such  as  Armour, 
Swift,  and  Morris,  started  a  great  many  years  ago  to  operate 
refrigerator  cars  primarily  for  transporting  their  own  products. 
As  a  "side  line"  they  began  to  run  these  cars  for  the  benefit 
of  producers  of  fruit  and  vegetables,  with  the  result,  as  is  well 
known,  that  operating  car  lines  became,  in  time,  one  of  the 
most  profitable  features  of  their  business. 

In  the  same  way  the  United  Fruit  Company  was  originally 
designed  merely  to  market  tropical  fruits,  especially  bananas. 
In  the  course  of  time,  however,  the  company  has  taken  over 
one  "side  line"  after  another  until  at  present  it  conducts  banana 
plantations,  sugar  plantations,  railroads,  tramways,  steamships, 
and  refrigerator  car  lines.  It  is  understood  that  each  of  these 
developments  has  proved  a  profit-maker  and  that  the  company's 
revenue  from  its  transportation  interests  is  almost  as  great  as 
from  its  original  field  of  operation. 

The  United  Cigar  Stores  Company  is  said  to  have  de- 
veloped successful  "side  lines,"  but  has  followed  the  policy 
of  selling  these  lines  after  they  were  developed  to  separately 
organized  and  managed  corporations.  The  profit-sharing 
coupons  of  the  company  have,  for  example,  been  taken  over 
by  the  United  Profit  Sharing  Corporation  and  the  sale  of 
chewing  gum  has  been  taken  over  by  the  Sterling  Gum  Com- 
pany. 


374 


INTERNAL   FINANCIAL   MANAGEMENT 


Perhaps  the  most  definite  conclusion  that  can  be  reached 
here  is  that  the  creation  of  ''side  hnes"  is  a  dangerous  business 
poHcy.  It  involves  a  diversion  of  capital,  of  thought,  and  of 
creative  energy  that  would  otherv^ise  go  into  building  up  the 
company's  ov^n  business.  This  is  especially  the  case  when  a 
"side  line"  is  taken  on  that  has  no  vital  or  necessary  connection 
with  the  original  and  proper  business  of  the  company.  In  that 
case,  it  calls  for  an  especially  heavy  drain  on  the  talent  and 
resources  of  the  company.  The  "side  line"  that  develops 
naturally  and  almost  unavoidably  is  of  a  different  type.  It 
may  be  considered  as  rather  in  the  nature  of  an  extension  than 
a  "side  line." 

Even  when  a  "side  line"  is  successful,  the  question  still 
remains  whether  the  application  of  an  equal  amount  of  capital 
and  of  managerial  ability  to  the  company's  own  product  would 
not  have  brought  still  greater  success.  Certain  it  is  that  those 
companies  which  have  achieved  the  greatest  records  of  growth 
are  those  which,  like  the  Ford  Motor  Company,  the  National 
Cash  Register  Company,  the  Curtis  Publishing  Company,  and 
thousands  of  others,  have  devoted  themselves  exclusively  to 
turning  out  one  or  two  cognate  products  and  have  never  al- 
lowed money  or  energy  to  be  diverted  from  this  main  purpose. 

Investing  Capital  in  Securities 

Under  this  head  we  have  to  consider  not  the  questions  that 
arise  in  connection  with  the  establishment  or  purchase  of 
partly  subsidiary  enterprises,  but  those  that  arise  in  connection 
with  using  the  surplus  funds  of  a  corporation  partly  for  in- 
vestment in  the  securities  of  non-related  corporations.  We 
shall  see  in  a  succeeding  chapter,  in  discussing  methods  of  utiK 
izing  surplus  funds,  that  some  corporations  make  it  a  practice 
to  place  a  portion  of  these  funds  in  salable  securities.  How- 
ever, this  is  seldom  carried  to  the  extent  of  tying  up  in  these 
investments  a  large  proportion  of  the   company's  available 


INVESTMENT   OF   CAPITAL   FUNDS 


375 


capital.  The  policy  to  be  considered  here  is  that  which  involves 
transforming  a  company  from  an  active  transportation,  public 
utility,  industrial,  or  trading  enterprise  into  a  company  that 
has  for  one  of  its  main  functions  investment  of  capital  in 
securities. 

It  is  seldom  that  this  transformation  is  effected  through  the 
desire  or  even  with  the  consent  of  the  great  body  of  stock- 
holders. It  is  much  more  commonly  the  case  that  the  active 
officers  or  directors  of  the  company  have  private  motives  of 
their  own  for  desiring  to  make  use  of  the  company's  credit 
and  other  resources.  The  results  achieved  may  conceivably 
in  the  long  run  be  beneficial  to  the  stockholders,  but  they  do 
not  affect  the  underlying  motive. 

This  appears  to  have  been  the  situation  with  the  Union 
Pacific  Railroad  Company  at  the  time  when  it  was  under  the 
domination  of  the  late  Mr.  E.  H.  Harriman.  Mr.  Harriman's 
first  efforts  were  directed  toward  making  the  Union  Pacific  an 
efficient  and  profitable  railroad  property.  Having  succeeded — 
or  being  well  on  the  way  toward  success — in  these  efforts,  his 
personal  ambitions  led  him  to  invest  the  surplus  profits  of  the 
Union  Pacific  more  and  more  heavily  in  other  railroad  com- 
panies and  to  utilize  the  credit  of  the  Union  Pacific  in  raising 
great  sums  of  money  for  the  purpose  of  consolidating  and 
extending  these  investments  in  other  railroad  properties. 
Thus,  in  the  course  of  time  the  Union  Pacific  became  half  a 
railroad  company  and  half  an  investment  company.  The 
decision  of  the  Supreme  Court  of  the  United  States  in  1912, 
which  compelled  the  Union  Pacific  to  part  with  its  holdings 
of  the  securities  of  certain  other  railroad  companies,  has  in 
part  remedied  but  has  not  completely  changed  this  state  of 
affairs. 

The  Adams  Express  Company  has  total  assets  of  approxi- 
mately $70,000,000,  out  of  which  "securities  and  investments" 
comprise  $57,000,000.     Its  total  earnings  from  investments 


376  INTERNAL   FINANCIAL   MANAGEMENT 

average  25  to  50%   higher  than  its  earnings  from  its  own 
operations. 

On  October  23,  19 14,  announcement  was  made  of  the 
appointment  of  a  receiver  for  the  Toledo,  St.  Louis  and  West- 
ern (Clover  Leaf)  Railroad.  Undoubtedly  the  prime  reason 
for  the  failure  was  the  investment  of  $11,500,000,  in  1907, 
in  common  and  preferred  shares  of  the  Chicago  and  Alton 
Railroad  Company.  The  dividend  record  on  the  acquired 
shares  was  as  follows : 


Common 

Preferred 

1907 

4% 

1908 

1% 

4% 

1909 

4% 

4% 

I9I0 

2% 

4% 

I9II 

2% 

I9I2 

No  dividends  since. 

When  in  1906  Mr.  E.  H.  Harriman  was  questioned  by  the 
Interstate  Commerce  Commission  as  to  the  status  of  the  Alton 
Railroad,  he  replied  quickly,  "You  will  have  to  ask  the  Rock 
Island  people;  they  are  carrying  the  bag."  The  following 
year  the  Rock  Island  succeeded  in  unloading  on  the  Clover 
Leaf.  The  loss  to  the  Rock  Island  on  this  transaction,  how- 
ever, was  heavy.  It  has  been  estimated  at  approximately 
$5,000,000. 

Another  painful  experience  in  making  investments  fell  to 
the  lot  of  the  Rock  Island  Company.  In  1902  Rock  Island 
purchased  Frisco  common  stock  to  the  par  value  of  $28,930,- 
300,  giving  in  payment  $60  per  share  in  5%  bonds  and  $60  in 
common  stock.  Seven  years  later  the  Rock  Island  manage- 
ment sold  the  Frisco  stock  back  to  the  original  vendors  at 
$37.50  per  share,  or  $10,848,250.  But  before  the  stock  could 
be  transferred,  it  was  necessary  to  pay  the  collateral  trust 


INVESTMENT    OF    CAPITAL    FUNDS  377 

bonds,  which  were  callable  at  102)^  and  interest.  To  pay  off 
these  bonds  required  $18,160,037  cash,  which  was  $7,311,175 
more  than  was  received  from  the  sale  of  the  Frisco  stock. 
To  raise  this  additional  cash,  $7,500,000  of  debenture  bonds 
were  issued.  During  the  seven  years  the  Rock  Island  owned 
the  Frisco  stock,  it  paid  out  in  interest  on  the  Frisco  collateral 
trust  bonds  $6,077,000,  and  did  not  receive  a  cent  of  dividends 
on  its  holdings  of  Frisco  stock.  The  actual  money  loss  to  the 
Rock  Island  Company  was,  therefore,  $13,388,175.  In  ad- 
dition, the  Rock  Island  Company  has  outstanding  $17,364,180 
of  its  ow^n  stock,  which  was  issued  in  part  consideration  for 
the  Frisco  stock. 

In  studying  the  records  of  large  corporations  which  have 
made  investments  on  a  great  scale,  one  is  more  and  more 
impressed  with  the  idea  that  the  men  at  the  head  of  these 
corporations  seem  at  times  to  lose  their  judgment  in  the 
handling  of  the  enormous  credit  power  that  is  under  their 
control.  They  are  apt  to  imagine  that  ordinary  rules  of  sound 
judgment  and  careful -figuring  do  not  apply  to  them.  They 
are  in  somewhat  the  same  state  of  mind  as  the  large  clothing 
manufacturer  to  whom  it  was  demonstrated  that  a  big  per- 
centage of  his  product  was  being  sold  below  cost,  *'0h,  that 
will  come  out  all  right,"  airily  replied  the  manufacturer.  "You 
overlook  the  great  scale  upon  which  our  operations  are  carried 
on." 

Another  factor  which  makes  for  recklessness  is  the  aston- 
ishing ease  with  which  large  corporations  can  issue  stocks  and 
bonds  in  exchange  for  property.  It  is  apparently  so  simple 
and  so  tempting  a  thing  to  do — to  have  a  few  more  pieces  of 
paper  engraved  and  given  in  exchange  for  railroads,  factories, 
and  control  over  the  labor  of  thousands  of  men — that  it  requires 
a  level  head  to  keep  clearly  in  mind  that  these  new  pieces  of 
paper  are  so  many  additional  obligations  which  sooner  or 
later  must  be  met. 


378 


INTERNAL   FINANCIAL   MANAGEMENT 


Relative  Amounts  of  Fixed  and  Working  Capital 

This  chapter  has  been  devoted,  in  part,  to  emphasizing  the 
necessity  for  providing  adequate  working  capital.  The  result 
may  be  to  restrict  the  investment  in  fixed  forms  and  thus 
to  limit  the  output  and  profit-making  possibilities  of  the  busi- 
ness. Such  a  policy  would  insure  a  degree  of  safety,  even 
in  the  presence  of  emergencies,  which  comes  only  from  the 
possession  of  an  adequate  working  capital.  The  popular  im- 
pression seems  to  be  that  it  is  absolutely  essential  for  a  corpor- 
ation to  possess  fixed  assets  which  will  enable  it  to  turn  out 
its  product,  whatever  that  product  may  be,  and  that  whatever 
sum  is  left  over  will  necessarily  have  to  serve  as  working 
capital.  There  is  probably  no  more  dangerous  fallacy  in  the 
whole  range  of  business  thought  and  action.  The  fact  of  the 
case  is  that,  for  most  corporations  adequate  working  capital 
is  essential,  while  adequate  fixed  capital  becomes  desirable 
and  necessary  only  after  the  success  of  the  business  has  been 
fully  demonstrated.  This  last  statement  is  not  intended  to 
apply,  of  course,  to  those  lines  of  business,  particularly  trans- 
portation and  public  utilities,  in  which  working  capital  is 
not  a  requisite. 

To  make  the  case  concrete,  let  us  suppose  that  a  water 
power  company  is  working  out  a  fully  completed  project  for 
installing  a  power  plant  and  for  serving  manufacturing  and 
public  utility  enterprises  throughout  a  given  district.  We  will 
assume  that  contracts  for  delivery  of  all  the  power  that  can  be 
produced  have  already  been  assured  and  that  the  payments 
on  these  contracts  are  to  be  made  monthly  in  advance.  Under 
these  conditions,  we  have  an  instance  of  a  corporation  which 
must  have  an  amount  of  fixed  capital  that  can  be  closely  esti- 
mated in  advance,  and  which  must  be  sufficient  to  enable  it  to 
complete  its  whole  installation.  It  needs  no  working  capital, 
for  the  monthly  cash  receipts  will  be  more  than  sufficient  to 
meet  its  monthly  outgo. 


INVESTMENT   OF    CAPITAL   FUNDS  379 

But  let  us  take,  also,  the  very  common  case  of  a  corporation 
which  is  designed  to  produce  and  sell  a  patented  device.  Fre- 
quently the  first  step  is  to  raise  whatever  fixed  capital  is 
required  in  order  to  build  a  plant  and  install  equipment.  Even 
though  the  company  may  have  sufficient  working  capital,  it 
is  more  than  likely  to  find  out  a  little  later  that  the  device 
itself,  or  the  methods  by  which  it  is  made,  are  not  in  their 
final  form  and  much  of  the  fixed  capital  will  be  wasted. 

A  far  more  sensible  procedure  in  most  cases  would  be  to 
have  the  device  manufactured  during  the  first  year  or  two  by 
some  company  which  will  take  over  the  manufacturing  con- 
tract, and  to  devote  all  the  available  capital  to  building  up  a 
selling  plan  and  selling  organization,  to  financing  sales,  to 
establishing  the  credit  of  the  new  corporation,  and  to  installing 
whatever  mechanical  or  business  improvements  are  called  for. 
That  is  to  say,  all  the  resources  at  the  beginning  should  be 
kept  in  the  form  of  working  capital.  After  the  selling  problem 
has  been  solved  and  the  final  form  of  the  product  has  been 
determined,  it  will  be  time  enough  to  proceed  with  the  erection 
of  a  plant.  If  this  procedure  were  more  generally  followed, 
there  would  be  fewer  setbacks  and  failures  in  business. 

A  closely  related  fallacy  is  the  common  idea  that  "more 
capital"  is  needed  in  order  to  make  a  business  move  ahead 
successfully,  whereas  the  real  need,  ordinarily,  is  for  a  better 
use  of  the  capital  already  available,  and  for  a  demonstration 
on  a  small  scale  that  the  enterprise  can  be  made  a  profit-maker. 
After  that  demonstration  has  been  given,  it  is  usually  compara- 
tively easy  to  raise  fresh  capital. 


CHAPTER  XVII    * 

CALCULATING    REQUIREMENTS    FOR    WORKING 

CAPITAL 

Factors  to  Be  Considered 

In  the  preceding  chapter  the  necessity  for  adequate  work- 
ing capital  in  most  lines  of  business  has  been  emphasized.  The 
question  as  to  what  is  to  be  considered  "adequate"  in  any  given 
case,  however,  has  been  left  open.  It  would  be  too  much  to 
expect  that  this  chapter  should  present  an  exact  arithmetical 
answer,  or  even  a  formula  for  arriving  at  the  answer.  There 
are  too  many  variable  factors  to  be  considered.  We  can,  how- 
ever, list  and  discuss  the  most  important  of  these  factors,  and 
perhaps  in  this  way  throw  a  little  additional  light  on  one  of 
the  most  difficult  and  most  vital  problems  in  the  field  of  busi- 
ness financing. 

Following  are  the  factors  which  require  chief  consideration 
when  the  amount  of  working  capital  required  by  a  given  enter- 
prise is  to  be  calculated : 

1 .  Length  of  period  of  manufacture. 

2.  Turnover. 

3.  Terms  of  purchase. 

4.  Terms  of  sale. 

5.  Facilities  for  converting  current  assets  into  cash. 

6.  Seasonal  variations  in  the  business. 

It  may  be  well  to  repeat  at  this  point  the  definition  of 
working  capital  as  "excess  of  current  assets  over  current  lia- 
bilities." In  transportation  and  other  enterprises  which  do 
not  carry  any  excess  of  assets  over  liabilities,  there  is  no 
working  capital;  in  manufacturing  enterprises  it  is  generally 

380 


REQUIREMENTS   FOR  WORKING   CAPITAL         ^^i 

considered  that  the  proportion  of  assets  to  liabilities  should 
not  be  lower  than  loo  to  75,  or  100  to  80.  Sometimes  the 
same  ratio  is  expressed  in  the  reverse  order,  and  it  is  stated 
in  mortgage  indentures  that  current  assets  shall  never  be  less 
than  133  1/3%  or  125%  of  current  Habilities.  These  ratios 
are  not  in  themselves  fixed  and  final  standards.  It  v^ould  be 
far  better  to  determine  the  amount  of  working  capital  in  some 
more  definite  manner;  if  the  amount  is  sufficient,  we  may  be 
certain  that  the  ratio  of  current  liabilities  to  current  assets 
will  always  be  well  within  the  limits  of  safety. 

Length  of  Period  of  Manufacture 

A  company  turning  out  a  product  which  requires  a  long 
period  of  manufacture  will  be  compelled  to  purchase  raw  mate- 
rials, pay  for  labor  and  other  expenses  incident  to  manufacture, 
and  wait  for  a  long  period  before  the  finished  product  is  ready 
to  sell.  Large  amounts  of  capital  will  necessarily  be  tied  up  in 
the  process  of  manufacture  itself.  As  an  extreme  instance, 
take  shipbuilding.  To  build  and  equip  a  large  vessel  may 
require  three  or  four  years.  The  outlay  may  amount  to  several 
millions  of  dollars.  In  case  the  product  is  not  paid  for  until 
delivery,  and  in  case  several  vessels  are  under  construction  at 
the  same  time,  it  is  clear  that  the  amount  of  capital  invested 
in  raw  materials,  partly  finished  products,  and  other  forms 
of  working  assets  will  soon  become  enormous.  Like  remarks 
apply  to  the  erection  of  large  buildings  or  other  important 
pieces  of  construction  which  may  require  several  years'  time 
and  the  investment  of  millions  of  dollars  before  the  product 
is  completed. 

In  these  extreme  instances,  the  problem  is  solved  by  throw- 
ing a  large  part  of  the  burden  of  providing  the  expenses  of 
construction  upon  the  purchaser.  Contracts  for  construction 
of  all  kinds  almost  invariably  provide  for  inspection  and  ac- 
ceptance of  the  work  that  has  been  completed  up  to  given  stages 


382  INTERNAL   FINANCIAL    MANAGEMENT 

or  at  given  intervals,  and  for  payment  on  account  by  the  pur- 
chaser of  a  proportionate  share  of  the  contract  price.  This 
arrangement  is  customary  even  with  comparatively  small  pieces 
of  construction,  such  as  the  installation  of  bank  vaults,  the 
erection  of  small  dwellings,  and  the  like. 

Even  with  this  proviso,  it  is  usually  the  case  that  con- 
struction and  contracting  firms  are  called  upon  to  lay  out  large 
sums  and  to  wait  for  a  considerable  period  before  they  are 
reimbursed,  and  it  is  quite  necessary,  therefore,  that  their 
working  capital  should  be  correspondingly  ample.  There  is 
scarcely  any  line  of  business  in  which  insolvencies  are  more 
frequent  than  in  contracting.  The  explanation  is  nearly  al- 
ways the  same;  the  working  capital  of  the  contracting  firm 
is  not  sufficient  to  "swing"  its  undertakings.  This  is  a  diffi- 
culty which  is  pecuHarly  apt  to  confront  all  enterprising, 
progressive,  and  otherwise  successful  contractors. 

In  the  extreme  instances  that  have  just  been  cited,  the 
necessity  of  securing  either  an  exceptionally  large  working 
capital  or  a  series  of  payments  on  account  in  advance  of  de- 
livery of  the  finished  product,  is  universally  recognized.  But 
there  are  rtiany  less  extreme  cases  in  which  the  importance  of 
this  factor  seems  easily  to  be  overlooked.  In  many  processes 
of  manufacture,  time  is  one  of  the  important  elements.  This 
is  true  particularly  in  handling  *'green"  products  such  as  lumber 
and  hides;  in  making  wines  and  distilling  liquors  of  good 
quality;  in  developing  suburban  real  estate;  and  so  on  indefi- 
nitely. The  moment  an  effort  is  made  to  rush  the  process  of 
turning  out  a  finished  product  in  any  of  these  lines,  the  result 
is  either  a  great  increase  in  expense  or  an  impairment  in 
quality.  On  the  other  hand,  it  must  not  be  forgotten  that  in 
slow  processes  provision  for  relatively  large  sums  of  working 
capital  must  be  made.  And  in  most  cases  it  is  not  practicable 
to  secure  payment  from  the  purchaser  in  advance  of  delivery 
of  the  finished  product. 


I 


REQUIREMENTS   FOR  WORKING   CAPITAL         383 

Moreover,  there  is  a  danger  connected  with  long-process 
manufacturing,  not  on  contract  but  for  the  general  market 
that  fluctuations  in  prices  may  diminish  or  wipe  out  expected 
profits.  To  take  care  of  such  fluctuations  and  to  carry  the 
company  through  periods  of  distress  which  may  result,  it  is 
essential  both  that  the  average  profits  should  be  high  and  that 
the  supply  of  working  capital  should  be  ample. 

This  was  one  of  the  main  sources  of  trouble  for  the  United 
States  Leather  Company  when  the  combination  was  first 
formed;  between  the  date  of  purchase  of  green  "packer"  hides 
in  this  country  and  the  actual  sale  of  the  finished  leather,  from 
six  to  twelve  months  usually  elapsed.  Between  the  purchase 
of  Argentine  hides  and  the  sale  to  a  foreign  consumer,  this 
period  may  be  extended  to  a  year  and  a  half  or  more.  At  a 
time  of  falling  prices,  the  price  of  hides  lags  behind  that  of 
leather.  As  a  result,  in  the  middle  90's,  the  United  States 
Leather  Company  repeatedly  sold  leather  for  less  than  its  cost 
of'  production.* 

Still  another  handicap  to  a  business  in  which  the  period  of 
manufacture  is  lengthy,  is  the  impossibility  of  making  quick 
adjustments  to  market  conditions.  By  way  of  contrast,  con- 
sider the  case  of  a  company  at  the  other  end  of  the  scale — a 
bread-baking  company,  which  manufactures  overnight  the 
product  that  it  sells  the  next  morning.  If  there  were  to  take 
place  a  sudden  shifting  of  demand  from  one  kind  of  bread 
to  another,  or  even  away  from  bread  altogether  toward  some 
other  kind  of  food,  the  bakers  obviously  could  adjust  them- 
selves to  the  change  in  short  order.  The  leather  manufacturer 
has  no  such  advantage.  He  is  continually  tied  up  with  enor- 
mous quantities  of  hides  and  of  leather  in  the  various  stages  of 
manufacture.  It  is  at  least  expensive,  and  in  many  cases 
impossible,  for  him  to  shift  from  one  kind  of  product  to  an- 
other.    He  may  suffer — and  in  fact  many  leather  manufac- 

•Dewing's  "Corporate  Promotions  and  Reorganizations,"  p.  25. 


384  INTERNAL    FINANCIAL    MANAGEMENT 

turers  have  suffered — severe  losses  due  simply  to  changes  in 
taste  on  the  part  of  the  consuming  public. 

It  is  clear  that  the  length  of  period  of  manufacture  is  an 
important  factor  in  determining  how  much  working  capital  a 
corporation  will  need.  A  breadmaker  does  not  risk  as  much 
in  proportion  to  the  volume  of  his  business  as  does  the  leather 
manufacturer ;  for  he  has  scarcely  paid  for  his  flour  and  labor 
before  the  receipts  from  his  sales  flow  back  to  him. 

One  important  improvement  in  automobile  manufacturing 
which  within  recent  years  has  put  it  on  a  safer  and  more 
stable  basis,  is  the  reduction  in  the  length  of  time  required  for 
turning  out  finished  cars.  ,  * 

Turnover 

A  closely  related  factor  is  the  rapidity  of  turnover  of 
working  capital.  Although  the  word  "turnover"  has  come  to 
be  highly  popular,  there  is  a  remarkable  absence  of  clear-cut, 
authoritative  definition.  Observation  of  customary  usage,  how- 
ever, makes  it  plain  that  its  meaning  in  the  minds  of  merchants 
and  manufacturers  is  always  the  same.  "Turnover"  may  be 
defined  as  the  ratio  of  annual  gross  sales  to  average  working 
assets.  It  is  the  figure,  in  other  words,  which  shows  how 
many  times  the  amount  invested  in  working  assets  has  been 
traded  in  or  "turned  over"  during  a  year.  Note  that  the 
relation  is  between  gross  sales  and  working  assets,  not  between 
gross  sales  and  working  capital.  There  would  be  some  ad- 
vantage in  basing  figures  on  the  second  relation,  but  it  is  not 
customary  to  do  so  and  it  seems  advisable  to  fall  into  line 
with  customary  business  practice. 

We  hear  a  great  deal  about  turnover  in  trading  operations, 
particularly  in  retail  merchandising,  and  comparatively  little 
about  it  in  manufacturing  operations.  It  is,  to  be  sure,  rela- 
tively of  greater  importance  to  the  merchandiser  than  to  the 
manufacturer,  but  it  is  by  no  means  unimportant  to  the  latter. 


REQUIREMENTS   FOR  WORKING   CAPITAL        385 

As  has  previously  been  remarked,  almost  all  the  assets  of  a 
trading  concern  are  working  assets;  the  only  capital  invested 
in  fixed  assets  is  that  which  is  given  up  to  office  furniture, 
store  equipment,  and  the  like.  Both  the  wholesaler  and  retailer 
customarily  buy  on  fairly  liberal  terms  of  credit  and  endeavor 
to  sell  the  merchandise  and  make  collections  before  their  bills 
for  the  merchandise  fall  due.  If  they  could  always  be  sure  of 
accomplishing  this  result,  there  would  be  no  necessity  for  their 
possessing  working  capital;  but,  as  we  shall  see  in  the  next 
section,  there  is  a  strong  tendency  in  this  country  toward  short- 
ening the  period  during  which  merchandise  bills  run  and  there 
is  also  an  ever-present  uncertainty  as  to  the  retailer's  ability  to 
dispose  of  his  products  within  any  fixed  period;  consequently, 
for  both  these  reasons,  he  is  called  upon  to  provide  a  certain 
amount  of  working  capital  and  often  a  very  large  amount. 
The  manufacturer's  proportion  of  working  capital  to  fixed 
capital  is  much  smaller  than  the  trader's  proportion.  Never- 
theless, up  to  the  extent  of  his  investment  in  working  capital, 
he  is  interested  as  well  as  the  trader  in  turnover. 

It  is  clear  that  the  greater  the  turnover,  the  larger  the 
volume  of  business  that  can  be  conducted  with  a  given  work- 
ing capital.  If  a  retail  store,  for  instance,  is  handling  a  product 
for  which  there  is  a  great  demand  and  which  can  be  sold 
almost  as  rapidly  as  it  fs  stocked,  the  gross  sales  will  be  large 
and  the  investment  in  stock  will  be  small.  If  sales,  on  the 
other  hand,  are  irregular  and  slow,  the  amount  of  working 
capital  invested  in  stock  will  necessarily  be  heavy. 

This  is  the  first  element  in  determining  the  rapidity  of 
turnover.  A  daily  newspaper  stand  will  necessarily  have  a 
very  rapid  turnover,  for  the  capital  invested,  plus  the  dealer's 
profit,  will  be  realized  in  cash,  at  least  once  a  day,  and  in  the 
larger  cities  three  or  more  times  a  day.  The  turnover  for 
the  newsdealer,  under  the  above  definition,  is  500  to  700 
times  per  year.     As  soon  as  the  newsdealer  adds  a  stock  of 


386 


INTERNAL   FINANCIAL   MANAGEMENT 


magazines  and  books,  which  sell  more  slowly,  his  turnover 
decreases.  At  the  other  end  of  the  scale  is  a  great  jewelry 
store,  such  as  Tiffany's,  in  which  it  is  necessary  to  provide  an 
immense  stock  of  valuable  goods  from  which  the  customer 
may  choose,  while  at  the  same  time  the  sales  are  compara- 
tively irregular  and  infrequent.  Evidently  the  turnover  in 
a  business  of  this  kind  must  be  small. 

In  addition  to  the  timeliness  of  the  merchandise  that  is 
carried  for  sale  and  the  degree  of  standardization  of  the 
merchandise,  which  determines  how  much  stock  must  be  car- 
ried in  order  to  give  a  satisfactory  range  of  choice  to  the 
customer,  another  element  that  determines  rapidity  of  turn- 
over is  the  sales  policy  of  the  merchandising  firm.  If  the 
sales  efforts  are  strongly  directed  toward  disposing  of  a  given 
stock  of  goods  quickly — if  necessary,  making  a  sacrifice  in 
price  or  incurring  an  extraordinary  selling  expense  in  order 
to  achieve  this  result — the  rate  of  turnover  will  clearly  be 
higher  than  in  case  there  is  no  definite,  clearly  thought-out 
sales  policy.  Right  here  is  the  point  at  which  the  financing 
of  great  numbers  of  retail  stores  breaks  down.  If  a  pro- 
prietor fails  to  recognize  the  great  importance  of  achieving 
volume  of  sales  and  rapidity  of  turnover,  even  though  an  inci- 
dental sacrifice  of  profits  here  and  there  may  be  involved, 
the  result  is  that  his  shelves  gradually  become  loaded  with 
unsalable  goods ;  his  receipts  are  not  sufficient  to  meet  promptly 
all  his  obligations  for  merchandise;  his  bills  accumulate  and 
his  credit  declines;  and  eventually  he  finds  himself — usually 
to  his  own  surprise — in  a  receivership  or  in  bankruptcy. 

Precisely  the  same  elements  determine  the  rapidity  of 
turnover  in  manufacturing  concerns.  The  timeliness  or  im- 
mediate salability  of  the  manufactured  product  determines 
whether  he  keeps  his  stock  of  raw  materials,  half-finished 
products,  and  finished  products  moving  or  whether  it  piles 
up  on  his  hands.     Second,  by  standardization  of  his  product. 


REQUIREMENTS   FOR  WORKING   CAPITAL         387 

accompanied  by  advertising  which  impresses  the  consumer 
with  the  superiority  of  the  standardized  product,  the  manu- 
facturer may  cut  down  the  number  of  his  styles  or  varieties 
that  he  turns  out.  The  automobile  manufacturers  have 
learned  that  one  or  two  styles  of  chassis,  each  with  two  or 
three  styles  of  body,  is  an  ample  line  for  any  one  manu- 
facturer. Those  that  have  been  most  successful  do  not  offer 
even  this  much  of  a  choice.  Thousands  of  manufacturers 
are  still  turning  out  a  large  variety  of  products  to  meet  the 
tastes — often  the  whims — of  customers,  when  it  would  be 
possible  for  them  to  standardize  both  the  demand  and  their 
own  output  and  thus  increase  to  a  wonderful  extent  the  turn- 
over of  their  working  assets.  The  third  element — definite 
sales  policy  which  endeavors  to  "clean  up"  accumulating 
stock — is  almost  as  essential  to  the  successful  manufacturer 
as  to  the  merchandiser. 

In  determining  the  rapidity  of  turnover  the  manufacturer 
is  more  or  less  circumscribed  by  one  element  that  does  not 
affect  the  merchandiser,  namely,  the  length  of  period  of  manu- 
facture. The  merchandiser  buys  only  finished  products,  and 
in  order  to  attain  a  satisfactory  turnover  has  only  to  stim- 
ulate the  sales.  The  manufacturer,  however,  if  his  period 
of  production  is  lengthy,  will  necessarily  have  a  small  ratio 
of  turnover  no  matter  what  sales  efforts  he  may  put  forth. 

It  would  be  impossible  to  state  definite  figures  for  turnover 
in  the  various  lines  of  business.  In  general  retail  store  mer- 
chandising, the  turnover  has  been  known  to  go  as  high  as  8  or 
10,  but  this  is  exceptional.  Ordinarily  2,  3  or  4 — depending 
on  the  location  of  the  store,  the  class  of  goods  carried,  and  so 
on — would  be  regarded  as  a  satisfactory  turnover. 

Investigations  carried  on  by  the  Bureau  of  Business  Re- 
search of  Harvard  University  show  that  the  rate  of  turnover 
in  retail  shoe  stores  ranges  from  i  up  to  3.6.  The  turnover 
in  a  large  number  of  these  stores  was  found  to  be  1.8,  and 


3^^ 


INTERNAL   FINANCIAL   MANAGEMENT 


the  Bureau  considers  a  turnover  of  2.5  as  a  realizable  stan- 
dard in  the  average  retail  shoe  store.* 

Terms  of  Purchase 

If  an  enterprise  is  paying  cash  for  everything  it  buys  and 
is  selling  on  credit,  it  will  obviously  need  a  working  capital 
sufficient  to  purchase  outright  its  entire  stock  of  goods,  includ- 
ing everything  that  has  been  sold  but  not  yet  paid  for.  On  the 
other  hand,  if  the  enterprise  is  able  to  buy  on  long  credit  and 
sell  for  cash,  it  can  provide  its  whole  stock  with  no  immediate 
outlay  and  will  pay  its  bills  as  they  mature  out  of  receipts 
from  its  own  sales.  Ordinarily,  neither  one  of  these  extreme 
arrangements  prevails.  Goods  are  both  bought  and  sold,  at 
least  in  part,  on  a  credit  basis. 

The  tendency  within  the  United  States,  however,  during 
the  last  two  or  three  decades  has  been  strongly  toward  reducing 
the  length  of  credit  available  to  purchasers  of  raw  materials  and 
of  goods  for  resale.  This  reduction  in  the  period  of  credit 
has  been  brought  about,  not  by  an  apparent  exercise  of  pres- 
sure, but  by  granting  special  "concessions"  to  those  who  were 
able  to  pay  cash  or  to  pay  within  10  to  30  days.  Gradually, 
as  these  concessions  have  come  to  be  more  and  more  accepted, 
the  competition  among  retailers  has  made  it  more  and  more 
necessary  that  they  should  be  accepted.  Moreover,  the  in- 
creasing tendency  in  this  direction  has  now  made  it  the  cus- 
tom in  many  lines  of  business  to  purchase  for  cash  or  on 
short  time,  and  has  therefore  placed  the  sellers  of  merchan- 
dise in  a  position  to  insist  upon  prompt  payment. 

In  retail  stores,  for  example,  forty  years  ago  it  was  not 
uncommon,  nor  was  it  considered  improper,  for  a  retail  mer- 
chant to  purchase  a  line  of  goods  on  six  months'  time.  Some- 
times he  was  compelled  to  ask  for  further  extensions.  A 
little  later  some  of  the  wholesalers  who  felt  the  need  of  more 


♦Bulletin  of  the  Bureau  of  Business  Research.  Harvard  University,  No.  1,  May, 
1913,  p.  14. 


REQUIREMENTS   FOR  WORKING  CAPITAL        389 

available  cash  in  their  own  business  began  to  offer  liberal  dis- 
counts for  payment  within  30  to  60  or  90  days ;  and  well-to-do 
retail  merchants  gladly  took  advantage  of  these  discounts. 
Other  merchants,  as  will  be  more  fully  explained  later  on 
in  this  chapter,  saw  the  advantage  to  themselves  of  borrow- 
ing from  their  local  banks  at  fairly  low  rates  of  interest,  thus 
securing  funds  with  which  they  could  take  advantage  of  the 
discounts  offered  to  them.  After  this  custom  became  firmly 
established,  the  wholesalers  began  to  expect  prompt  payment 
and,  although  the  terms  were  still  nominally  three  months 
to  six  months  with  a  discount  for  anticipating  payment,  the 
wholesaler  based  his  calculations  on  the  cash  price  and  the 
so-called  ''discount"  came  to  be  more  and  more  in  the  nature 
of  a  penalty  imposed  upon  those  who  failed  to  pay  their  bills 
within  10  to  30  days.  So  well  understood  is  this  custom 
at  the  present  time,  that  a  merchant  who  fails  to  take  ad- 
vantage of  the  cash  discount  offered  to  him  is  soon  looked 
upon  with  suspicion. 

Any  so-called  discount  which  is  far  in  excess  of  customary 
rates  of  interest  is  to  be  regarded  as  a  penalty  for  non-payment 
of  bills  rather  than  as  an  incentive  to  prompt  payment.  A 
striking  example  is  the  custom  among  periodicals  of  render- 
ing bills  for  advertising  space  nominally  payable  within  30 
days,  but  with  a  discount  of  2  to  5%  for  payment  within 
10  days.  Inasmuch  as  these  bills  are  customarily  rendered 
before  the  issue  containing  the  advertisement  is  actually  ready 
for  distribution,  the  publisher  usually  receives  his  payment 
in  advance  of  any  service  that  he  has  rendered  to  the  adver- 
tiser. Doubtless  the  custom  arose  out  of  the  danger  that 
advertising  space  may  be  lightly  ordered  by  concerns  which 
have  little  real  use  for  it  or  are  unable  to  pay  for  it;  hence 
the  publisher  feels  justified  in  practically  demanding — through 
the  medium  of  abnormal  discount  rates  —  that  payment  be 
made  in  advance. 


300  INTERNAL   FINANCIAL   MANAGEMENT 

In  the  "capital-poor"  countries  in  which  industry  and  trade 
are  constantly  tending  to  expand  more  rapidly  than  adequate 
capital  for  developing  them  can  be  obtained,  the  custom  of 
granting  long  terms  to  purchasers  for  manufacture  or  re- 
sale, which  formerly  prevailed  in  this  country,  continues  to 
exist.  In  Argentina,  for  example,  it  has  during  recent  years 
been  customary  for  importers  and  wholesalers  of  merchandise 
to  sell  to  the  general  retailers  in  the  farming  districts  on  90 
to  180  days'  time  and  in  addition  make  liberal  provisions 
for  renewal  of  the  retailer's  obligations.  In  turn,  the  re- 
tailer customarily  sold  goods  to  the  farmers  and  others  in 
his  district  on  similar  long  terms.  Frequently,  the  retailer 
was  able  to  go  a  step  further  and  actually  make  advances  to 
his  customers  in  order  to  enable  them  to  carry  on  their  farm- 
ing operations  and  harvest  their  crops.  Each  year  as  the 
crops  were  brought  to  the  market  and  sold,  the  farmers  were 
able  to  repay  the  merchants  for  all  the  advances  and  the 
goods  they  had  received  during  the  preceding  several  months, 
and  the  retail  merchant  was  then  in  position  to  settle  his 
obligations  to  the  wholesaler,  who  in  turn  was  able  to 
clear  up  his  obligations.  Under  this  system  the  importer  and 
wholesaler  were  "carried"  in  part  by  the  manufacturers — 
chiefly  in  foreign  countries — frorn  whom  they  purchased; 
the  retailers  were  "carried"  by  the  wholesale  dealers;  and 
the  farmers  and  other  consumers  of  goods  were  "carried" 
by  the  retail  merchants.  In  years  when  the  crops  were  good, 
the  harvest  months  were  a  period  of  rejoicing  and  realiza- 
tion of  good  profits  on  the  part  of  every  one.  When  the 
crops  were  bad,  the  entire  structure  of  mercantile  credit  was 
shaken  and  a  large  proportion  of  the  weaker  concerns  inevi- 
tably went  to  the  wall. 

In  European  countries  the  general  custom  prevails  of  ac- 
companying invoices  for  shipments  of  goods  with  drafts 
drawn  on  the  purchaser  usually  for  30  or  60  days..    After 


REQUIREMENTS    FOR  WORKING   CAPITAL 


391 


receiving  the  goods  and  satisfying  himself  that  they  are  in 
good  condition,  the  purchaser  "accepts"  the  draft  which  then 
becomes  an  obligation  on  his  part  of  the  same  general  char- 
acter as  if  he  had  given  a  promissory  note.  The  "accepted" 
draft  may  be  discounted  by  the  house  which  sold  the  goods, 
at  its  own  bank  or  may  even  be  sold  in  the  open  market. 
At  any  rate,  the  seller  of  the  goods  quickly  and  easily  col- 
lects payment,  while  the  purchaser  of  the  goods  has  an  oppor- 
tunity to  adjust  his  affairs,  knowing  that  he  will  be  called 
upon  to  meet  his  accepted  draft  on  a  given  day.  This  sys- 
tem is  claimed  by  many  bankers  to  have  noteworthy  ad- 
vantages over  the  custom  which  prevails  in  the  United  States 
of  persuading  the  retailer  through  the  use  of  penalty  dis- 
counts to  pay  cash  for  his  purchases. 

The  system  prevailing  in  this  country  is  made  possible 
only  by  the  existence  of  great  numbers  of  local  banks.  The 
local  merchant  is  in  position  to  borrow  from  these  banks  and 
thus  to  take  upon  his  own  shoulders  the  whole  burden  of 
financing  his  purchases  of  goods,  whereas  in  other  countries 
the  seller  of  the  goods,  either  through  his  own  resources  or 
through  his  banking  connections,  attends  to  the  financing 
of  the  transaction.  The  same  custom  has  not  as  yet  come 
to  prevail  when  the  manufacturers  are  the  purchasers  of 
goods.  Ordinarily  they  buy  on  30  to  90  days'  time,  or  in 
case  of  special  and  exclusive  contracts  often  on  longer  time. 
It  Is  usual,  however,  when  accounts  run  for  longer  than 
two  to  four  months,  for  the  purchaser  to  give  in  payment 
his  promissory  note  which  the  seller  may  then  discount  at 
his  own  bank.  The  tendency  is  strong  even  here  to  reduce 
the  period  of  credit  and  through  the  offer  of  discounts  to 
bring  pressure  to  bear  for  the  prompt  cash  payment  of 
accounts.  Unless  some  contrary  tendency  should  make  it- 
self felt,  we  may  reasonably  expect,  as  time  goes  on,  to  see 
the  burden  of  financing  dealings  in  raw  materials,  as  well 


392  INTERNAL    FINANCIAL    MANAGEMENT 

as  in  finished  products,  assumed  to  a  greater  and  greater 
extent  by  the  purchaser. 

The  effect  of  this  tendency  on  working  capital  is  self- 
evident.  When  the  purchases  of  a  firm  are  made  on  long- 
term  credits  and  money  is  collected  from  sales  before  the 
corresponding  obligations  fall  due,  working  capital  is  re- 
quired only  to  take  care  of  emergencies.  But  when  the  pur- 
chaser undertakes  to  pay  cash,  he  must  either  possess  so 
much  working  capital  that  he  can  make  payment  out  of  his 
own  resources,  or  at  least  he  must  possess  enough  to  provide 
a  margin  of  safety  which  will  enable  him  to  borrow  from 
banks  without  question  and  on  favorable  terms.  The  shorter 
the  period  of  credit  that  is  customarily  used  by  a  firm  in 
making  purchases,  the  larger  must  be  the  working  capital 
of  the  firm. 

Terms  of  Sale 

Looking  now  at  dealings  in  raw  materials  and  merchan- 
dise from  the  seller's  point  of  view,  let  us  consider  the  effect 
upon  working  capital  of  the  customary  or  average  terms  of 
sale.  We  shall  give  particular  attention  to  two  classes  of 
transactions  that  were  not  treated  in  the  preceding  section, 
viz.,  sales  to  purchasers  in  foreign  countries  and  sales  by  the 
retailer  to  the  consumer. 

So  far  as  dealings  between  producers  and  those  who  pur- 
chase for  manufacture  or  resale  are  concerned,  these  deal- 
ings have  been  discussed  at  sufficient  length  in  the  preceding 
pages.  It  is  enough  here  to  state  the  corollary  of  the  con- 
clusion therein  reached,  viz.,  the  longer  the  period  of  credit 
which  it  is  necessary  to  extend  in  effecting  sales,  the  larger 
must  be  the  amount  of  working  capital. 

There  are  some  special  considerations,  however,  that  mod- 
ify this  conclusion  in  its  application  to  financing  sales  in  for- 
eign countries.     These  special  considerations  arise  out  of  the 


REQUIREMENTS    FOR  WORKING   CAPITAL         393 

fact  that  the  methods  of  financing  these  foreign  sales  differ 
somewhat  from  the  method  of  financing  a  domestic  sale. 
First  of  all,  the  domestic  sale  is  usually  on  open  account; 
hence,  the  seller  does  not  come  into  possession  of  a  piece  of 
commercial  paper  which  he  can  readily  discount.  When 
the  terms  of  credit  are  longer  than  two  to  four  months,  as 
has  been  noted  above,  the  principal  may  give  his  promissory 
note,  but  it  is  not  the  customary  type  of  transaction  in  this 
country.  In  foreign  trade,  however,  the  European  custom,  is 
followed  of  accompanying  the  shipments  of  goods  with  a  draft 
drawn  upon  the  purchaser.  In  the  South  American  trade 
this  draft  is  usually  due  for  payment  90  days  after  the  goods 
have  arrived  at  their  destination;  on  arrival  of  the  goods  it 
is  expected  that  the  purchaser  will  promptly  inspect  them 
and,  if  they  are  in  accordance  with  his  order,  will  "accept" 
the  draft  which  in  the  meantime  will  have  been  forwarded 
to  one  of  his  local  banks.  Inasmuch  as  it  requires  at  least 
a  month,  or  usually  more  on  an  average,  to  secure  delivery 
of  shipments  from  this  country  to  South  American  countries, 
and  another  month  is  required  before  funds  paid  at  a  South 
American  city  can  be  transferred  by  mail  to  a  city  within 
the  United  States,  there  is  an  interval  of  at  least  five  months 
to  be  bridged  over  between  the  date  of  shipment  and  the 
date  of  receiving  payment — one  month  for  the  shipment  and 
draft  to  reach  destination,  three  months  until  maturity  of 
the  draft,  and  one  month  thereafter  until  payment  reaches 
the  shipper  in  the  United  States.  It  should  be  borne  in  mind, 
also,  that  five  months  is  almost  the  minimum  period.  In 
case  it  is  desirable  or  necessary  to  renew  the  draft,  or  in  case 
communication  requires  more  than  one  month,  the  period 
before  final  payment  is  received  may  drag  out  to  six  or  nine 
months  or  even  more. 

If  a  manufacturer  Is  to  build  up  export  trade  as  an  im- 
portant feature  of  his  business,  it  is  evident  that  he  must  either 


394 


INTERNAL   FINANCIAL   MANAGEMENT 


provide  a  great  addition  to  his  working  capital  or  he  must 
have  assistance  of  some  kind  in  financing  this  export  trade. 

In  the  countries  which  are  the  chief  commercial  competi- 
tors of  the  United  States — England  and  Germany — systems  of 
financing  foreign  sales  are  worked  out  in  great  detail;  and 
this  constitutes  one  of  the  most  important  advantages  which 
these  countries  enjoy  in  competing  with  American  manufac- 
turers in  such  markets  as  those  of  the  Far  East  and  South 
America.  A  like  system  is  now  in  process  of  formation  in 
this  country.  It  is  to  be  hoped  that  it  will  be  completely 
worked  out  in  time  to  enable  American  manufacturing  ex- 
porters to  get  a  firm  hold  on  the  trade  in  competitive  markets 
during  the  present  favorable  conditions. 

Basically  there  are  five  possible  methods  under  which  the 
manufacturer  who  is  making  export  shipments  may  quickly 
realize  the  cash  value  of  his  shipments : 

1.  He  may  turn  over  the  financing  (with  or  without  the 
selling)  to  a  firm  of  commission  merchants  who  agree  to  pay 
the  manufacturer  in  cash  and  to  charge  a  sufficiently  higher 
price  to  the  customer  to  compensate  them  for  their  special 
knowledge,  advances  of  money,  and  risk.  In  some  lines,  and 
with  the  proviso  that  the  right  kind  of  contract  is  made  with 
commission  houses,  this  may  prove  to  be  a  satisfactory  method. 

2.  The  exporter  may  carry  through  his  own  sales,  draw  a 
draft  in  accordance  with  the  usual  custom  to  accompany  the 
shipment,  turn  the  draft — or  bill  of  exchange  as  it  is  more 
commonly  called — over  to  his  local  bank  to  send  forward  for 
collection,  and  on  the  strength  of  this  increased  business  secure 
from  his  bank  an  enlarged  line  of  credit.  This  is  very  much 
the  same  plan  that  would  be  followed  if  the  manufacturer  were 
to  increase  his  domestic  business.  It  is  usually  highly  unsat- 
isfactory as  a  means  of  financing  export  shipments,  however, 
because  the  banker  is  seldom  willing  to  grant  credit  for  a  suffi- 
cient length  of  time,  or  to  a  large  enough  amount,  to  ^ive  the 


REQUIREMENTS   FOR  WORKING   CAPITAL         395 

manufacturer  all  the  assistance  that  he  needs.  In  other  words, 
under  this  plan  it  is  necessary  for  the  manufacturer  largely 
to  increase  his  working  capital  in  order  to  handle  export  trade 
and  this  places  him  at  a  disadvantage  as  compared  with  his 
foreign  competitors. 

3.  The  manufacturer  may  forward  his  bills  of  exchange 
for  collection  through  his  bank,  and  arrange  with  the  bank  to 
give  him  an  advance  up  to  a  fixed  percentage  of  each  draft. 
This  percentage  may  be  as  low  as  50%  or  as  high  as  90%, 
or  even  95%.  This  is  certainly  a  better  arrangement  both 
for  the  manufacturer  and  for  the  banker,  inasmuch  as  it  gives 
the  manufacturer  a  larger  amount  of  available  credit  which 
varies  in  direct  proportion  to  his  foreign  business,  and  gives 
the  banker  a  direct  collateral  of  good  quality  to  secure  his 
advances.  Until  recently  it  has  been  the  method  most  widely 
used  within  the  United  States,  and  is  also  much  used  in 
England  and  Germany.  The  chief  objection  to  it  is  that  it 
does  not  go  far  enough,  inasmuch  as  the  percentage  of  safety 
which  the  American  banker  requires  is  much  higher  than  the 
percentage  customarily  required  in  competitive  countries. 

4.  The  exporter  may  actually  "discount"  or  "sell"  his  bill 
of  exchange,  to  a  banker  who  is  doing  business  through  a 
branch  or  through  a  closely  allied  correspondent  in  the  district 
to  which  the  shipment  is  going.  The  bill  is  usually  bought 
"with  recourse,"  which  means  that  the  banker  reserves  the 
right  to  demand  payment  of  the  draft  from  the  exporter  in 
case  the  importer  fails  to  meet  it  promptly.  It  is  usually 
discounted  at  6%,  more  or  less,  with  an  additional  commis- 
sion charge  of  perhaps  3^%.  This  is,  on  the  whole,  a  sat- 
isfactory method  of  financing  so  far  as  the  manufacturer  is 
concerned.  He  gets  his  money,  minus  a  reasonable  discount 
and  commission  charge,  at  once,  and  thus  is  not  stripped  of 
working  capital.  To  be  sure,  a  contingent  liability  remains, 
but,  unless  his  sales  policy  is  defective  in  the  extreme,  there 


396 


INTERNAL   FINANCIAL   MANAGEMENT 


will  be  very  few  cases  in  which  his  bills  go  to  protest.  The 
chief  objection  is  that  the  banks  of  the  United  States  are  not, 
as  a  rule,  sufficiently  well  represented  abroad  to  carry  on  this 
business,  so  that  it  is  conducted  chiefly  by  agencies  of  foreign 
banks  in  New  York  City. 

5.  The  exporter  may  turn  over  his  bill  to  his  bank  to  for- 
ward for  collection,  and  the  bank  in  turn  may  permit  the 
exporter  to  draw  another  draft  on  the  bank,  which  the  bank 
''accepts."  The  exporter  may  then  take  this  "accepted"  draft 
into  the  open  market  and  sell  it  for  whatever  it  will  bring.  In- 
asmuch as  an  accepted  draft  is  practically  equivalent  to  a 
promissory  note,  those  drafts  which  have  been  accepted  by 
strong  banks,  are  salable  at  a  very  low  discount  rate.  The 
bank  charges  a  small  commission,  equivalent  to  about  i  to  2% 
per  annum,  for  stamping  its  acceptance  on  a  draft.  Usually 
the  draft  drawn  on  a  bank  is  for  80  to  95%  of  the  amount  of 
the  exporter's  draft  on  his  customer.  This  method  has  been 
possible  in  the  United  States  only  since  the  Federal  Reserve 
Act  went  into  effect  in  November,  19 14.  It  is  simple  and 
practical  and  gives  to  most  exporters  the  financial  assistance 
that  they  require.  Usually  the  manufacturer  is  able,  through 
this  method,  to  get  returned  at  once  at  least  the  full  amount 
of  the  cost  to  him  of  manufacturing  and  selling  the  goods 
he  is  shipping,  and  is  compelled  to  wait  only  for  his  profit  on 
the  transaction.  That  being  the  case,  he  may  carry  on  as 
much  export  trade  as  can  be  financed  in  this  way  without 
direct  increase  in  his  working  capital. 

As  was  remarked  in  the  preceding  section,  the  English 
custom  is  to  accompany  almost  all  shipments,  domestic  as  well 
as  foreign,  with  drafts,  which  are  accepted  by  the  purchasing 
house  and  thereupon  become  a  good  quality  of  marketable 
paper  which  banks  are  quite  ready  to  discount.  This  system 
enables  the  manufacturer  to  borrow  large  amounts  from  his 
banks  with  safety,  and  to  count  upon  this  borrowing  as  a 


REQUIREMENTS    FOR  WORKING   CAPITAL         397 

permanent  source  of  funds  not  subject  to  the  more  or  less 
arbitrary  conditions  that  bankers  find  it  necessary  to  impose 
under  the  American  system.  The  Enghsh  manufacturers  and 
trades,  therefore,  are  in  position  to  carry  on  their  business 
with  a  much  smaller  amount  of  working  capital  than  is  re- 
quired by  a  business  of  corresponding  volume  in  this  country. 
Take  an  example  at  random:  The  well-known  Enghsh  firm 
of  Bolckow  and  Vaughan,  manufacturers  of  iron  and  steel,  car- 
ried on  a  recent  balance  sheet  current  assets  as  follows : 

Sundry  Debtors  (Accounts  Receivable)   £224,000 

Stocks  (Inventories)   750,000 

Cash 39,000 

Total £1,013,000 

The  Sundry  Creditors  (Accounts  Payable)  were  listed  at 
£500,000. 

Note  the  remarkably  small  amount  of  cash  in  proportion 
to  the  current  assets  and  liabilities.  The  fact  that  so  large 
and  prosperous  a  firm  should  carry  so  little  cash  can  be  ac- 
counted for  only  as  a  result  of  the  English  practice  with 
regard  to  financing  sales  which  has  just  been  alluded  to. 
Under  this  practice  it  is  easy  for  the  manufacturer  or  trader 
to  realize  on  his  sales  and  secure  whatever  cash  he  needs  on 
short  notice. 

For  this  reason  it  is  important  that  better  facilities  should 
be  developed  in  the  United  States  for  financing  sales  abroad 
and  long-term  sales  within  this  country.  If  this  were  done,  and 
probably  it  will  be  done,  the  amount  of  working  capital  re- 
quired to  handle  a  given  volume  of  business  would  be  much 
reduced.  For  the  time  being,  however,  and  until  these  facili- 
ties are  more  fully  and  more  efficiently  supplied,  we  must  in 
many  cases  figure  that  any  increase  in  sales  which  is  accom- 
panied by  a  lengthening  of  the  terms  of  payment  will  neces- 
sarily involve  a  disproportionate  addition  to  working  capital. 


398 


INTERNAL   FINANCIAL   MANAGEMENT 


Financing  Instalment  Sales 

Another  highly  important  departure  In  American  business 
practice  which  involves  difficulties  of  financing  and  calls  for 
some  special  consideration,  is  the  growth  in  the  custom  of 
making  retail  sales  of  high-priced  goods,  payments  for  which 
are  deferred  and  are  made  in  instalments.  This  is  a  practice 
which  already  has  a  wide  application  and  which  gives  promise 
of  spreading.  Originally,  "selling  on  the  instalment  plan"  was 
confined  largely  to  high-priced  sets  of  books  and  a  few  other 
articles  of  luxury.  At  the  present  time,  however,  it  is  the 
customary  plan  of  sale  in  such  widely  separated  lines  as  pianos, 
suburban  real  estate,  agricultural  machinery,  courses  of  in- 
struction, and  sewing  machines.  It  is  being  introduced  more 
and  more  also  in  selling  clothing,  furniture,  jewelry,  motor 
cycles,  automobiles,  and  many  other  articles. 

There  has  been  much  opposition  to  this  wide-spread  use 
of  the  instalment  plan,  on  the  ground  that  it  leads  thousands 
of  im.prudent  people  into  buying  articles  that  they  do  not  need 
and  incurring  debts  which  easily  grow  to  be  a  serious  burden. 
In  so  far  as  the  instalment  plan  is  used  in  selling  articles  of 
luxury  that  do  not  in  any  way  add  to  the  efficiency  or  the 
earning  power  of  the  buyer,  this  objection  seems  to  be  well 
founded.  It  is  equally  clear,  however,  that  the  objection  does 
not  apply  when  the  article  that  is  sold  tends  to  increase  earn- 
ing power;  for  in  that  case  the  purchaser  is  simply  making 
use  of  his  credit,  just  as  every  business  house  should  do,  in 
order  to  enlarge  his  facilities  for  carrying  on  his  activities  as 
profitably  as  possible.  He  is  following  the  same  policy  that 
the  railroad  follows  when  it  purchases  rolling  stock  on  the 
instalment  plan  and  gives  its  equipment  notes  in  payment. 

However,  we  need  not  here  enter  into  any  discussion  of  the 
social  aspects  of  instalment  selling.  The  only  point  that  really 
concerns  us  is  the  financial  problem  that  confronts  the  manu- 
facturer or  retailer  who  adopts  the  instalment  plan.     Fre- 


REQUIREMENTS    FOR  WORKING   CAPITAL         399 

quently  it  has  been  adopted  without  .the  slightest  realization, 
apparently,  that  any  financial  problem  accompanies  it.  As  a 
result,  hundreds — or  more  likely  thousands — of  instalment 
houses  in  various  lines  of  business  have  been  wound  up  in 
bankruptcy  proceedings  and  the  whole  method,  no  matter  how 
it  may  be  applied,  has  come  to  be  looked  upon  by  bankers  wuth 
much  distrust.  Here,  again,  some  discrimination  should  be 
used. 

The  financial  difficulty  arises  out  of  the  simple  fact  that 
the  whole  cost  of  the  product  that  is  being  sold,  plus  the  cost 
of  selling  and  of  overhead  administration,  is  paid  out  before 
the  product  is  delivered  to  the  customer,  whereas  payment  is 
received  only  in  small  periodic  amounts  extending  usually  over 
several  months.  In  disposing  of  real  estate  on  the  instalment 
plan,  it  is  not  uncommon  for  payments  to  be  spread  over  five 
to  ten  years  or  even  longer.  In  selling  pianos  the  payments 
frequently  spread  over  as  long  as  three  years ;  in  selling  furni- 
ture, agricultural  machinery,  and  the  like,  the  term  of  pay- 
ment is  customarily  about  one  year. 

A  secondary  financial  difficulty  arises  out  of  the  fact  that 
a  certain  proportion  of  the  sales  will  be  made  to  people  who 
cannot,  or  will  not,  live  up  to  their  contracts.  The  manufac- 
turer or  retailer  may  then  proceed  to  take  back  his  goods,  but 
they  will  usually  be  in  a  damaged  condition.  In  any  case  the 
expense  of  making  and  handling  the  sale  and  of  attempting 
to  collect  the  instalment  payment  will  have  been  incurred  and 
cannot  be  recovered.  The  expenses  and  losses  of  collection 
together  constitute  an  item  that  must  be  carefully  calculated 
and  taken  into  consideration  in  every  instalment  business. 

The  simplest  and  one  of  the  most  common  forms  of  instal- 
ment contract  is  an  agreement  on  the  part  of  the  purchaser 
to  pay  the  fixed  price  of  the  article  he  acquires  at  the  periods 
and  in  the  amounts  agreed  upon,  in  return  for  which  the 
purchaser  obtains  full  possession  of  and  title  to  the  goods. 


^OO  INTERNAL    FINANCIAL    MANAGEMENT 

The  seller  under  this  agreement  has  practically  nothing  ex- 
cept an  "open  account"  against  the  purchaser.  He  depends 
largely  upon  the  purchaser's  good  faith  and  on  the  average 
honesty  of  the  people  he  is  dealing  with,  which  is  usually  high. 
It  is  this  last  element — the  average  honesty  of  his  customers — 
which  constitutes  the  seller's  chief  protection  and  chief  asset. 
He  may,  of  course,  be  able  to  enforce  collection  by  legal 
process,  and  will  probably  make  it  his  policy  to  do  so  when- 
ever a  purchaser  gives  evidence  of  acting  in  bad  faith;  but 
if  he  were  compelled  to  make  any  large  proportion  of  his  col- 
lections by  legal  process,  he  would  be  out  of  business  in  a 
short  time.  In  spite  of  its  apparent  looseness  and  the  heavy 
risk  which  the  owner  of  merchandise  appears  to  take  whenever 
he  parts  with  it  on  such  terms,  instalment  houses  that  are 
selling  a  really  meritorious  product  by  proper  methods  to  a 
good  class  of  people  find  that  they  can  count  with  perfect 
safety  on  only  a  small  proportion  of  expenses  and  losses  in 
making  collections. 

Where  the  amount  involved  in  each  sale,  however,  is  large, 
or  where  it  is  desirable  to  reserve  as  full  protection  as  possible 
for  the  selling  house  in  order  to  satisfy  bankers'  ideas,  two 
variations — both  designed  for  the  protection  of  the  seller — 
may  be  introduced.  One  of  these  variations  consists  of  retain- 
ing title  to  the  property  in  the  hands  of  the  seller  until  after 
the  agreed  price  has  been  paid  in  full.  This  is  the  arrange- 
ment when  equipment  is  sold  to  railroad  companies.  It  is 
customary  in  selling  pianos,  furniture,  real  estate,  and  many 
other  high-priced  articles.  The  legal  interpretation  of  what 
is  commonly  known  as  a  "lease  contract,"  under  which  the 
instalment  payments  are  technically  regarded  as  rental  until 
after  the  final  instalment  has  been  paid,  when  title  passes  to 
the  purchaser,  varies  from  one  jurisdiction  to  another.  In 
some  states  it  has  been  held  to  be  practically  the  equivalent 
of  a  sale  and  the  title  is  regarded  as  having  passed  to  the 


REQUIREMENTS   FOR  WORKING   CAPITAL         401 

purchaser  at  the  beginning  of  the  transaction.  In  most  juris- 
dictions, however,  the  lease  form  of  contract  is  upheld.  Much 
indignation  has  been  aroused — some  of  it  doubtless  justified 
— at  the  attitude  of  some  dealers  who  have  sold  furniture 
under  lease  contracts  and  at  the  first  sign  of  default  have  taken 
back  the  furniture  and  at  the  same  time  retained  all  the  pay- 
ments that  have  been  made  by  the  purchaser.  There  often 
seems  to  be  injustice  in  such  procedure;  and  yet  the  seller 
may  usually  claim  with  truth  that  he  is  actually  the  chief  loser 
in  every  such  case  and  it  is  necessary  for  him  to  take  drastic 
action  in  order  to  protect  himself  against  fraud. 

The  second  variation  is  that  of  requiring  the  purchaser  to 
give  a  series  of  notes  covering  his  instalment  payments.  This 
puts  the  transaction  into  a  much  more  definite,  irrevocable 
form,  and  also  assists  the  seller,  as  we  shall  see  presently, 
in  making  his  financial  arrangements.  Where  the  amount  is 
large — say  several  hundred  dollars  or  more — it  is  almost  al- 
ways wise  to  require  the  purchaser  to  give  a  series  of  notes. 
Where  the  amount  of  the  transaction  is  small,  the  difiiculty  of 
getting  the  notes  and  the  annoyance  which  the  customer  feels 
in  giving  a  note  for  a  small  amount  are  drawbacks  which  are 
not  compensated  for  by  any  general  increase  in  the  seller's 
safety.  It  does  not  pay  to  sue  for  payment  of  notes  of  small 
denomination.  Except  for  a  shadowy  moral  influence,  there- 
fore, the  instalment  seller  is  not  materially  better  off  for  hav- 
ing the  small  notes  in  his  possession  than  when  he  simply  has 
on  his  books  an  open  account  against  the  purchaser. 

Working  Capital  Requirements  for  Instalment  Selling 

Coming  back  now  to  the  financial  problem  of  carfying  on 
an  instalment  business,  let  us  take  the  hypothetical  case  of  a 
product  which  sells  at  a  retail  price  of  $100.  We  will  say 
that  the  cost  to  the  manufacturer  or  retailer  is  $60,  the  selling 
expense  is  $20,  and  the  overhead  charges,  including  collection 


402 


INTERNAL   FINANCIAL   MANAGEMENT 


expense  and  loss,  are  $io,  leaving  net  profits  of  $io.  We 
will  assume  that  the  firm  which  sells  this  product  disposes  of 
50  of  the  articles  during  the  first  month  of  operations;  100 
the  second  month ;  1 50  the  third  month ;  200  the  fourth  month ; 
and  thereafter  regularly  sells  200  each  month.  We  will  as- 
sume, furthe.r,  that  instalment  payments  are  made  at  the  rate 
of  $10  per  month.  In  order  to  simplify  the  problem,  we  will 
make  the  arbitrary  assumption  that  the  whole  $90  outgo, 
including  collection  expense  and  loss,  is  incurred  at  the  time 
each  sale  is  made.  Under  these  assumed  conditions,  how 
much  working  capital  will  be  required  to  "swing"  the  stated 
volume  of  business  ?  During  the  first  month  the  outgo  would 
be  50  times  $90,  or  $4,500  and  the  cash  receipts  would  be  50 
times  $10,  or  $500,  leaving  a  cash  deficiency  of  $4,000.  During 
the  second  month  the  outgo  would  be  100  times  $90,  or  $9,000, 
while  the  receipts  would  be  $500  covering  sales  made  during 
the  first  month,  plus  $1,000  for  sales  during  the  second  month, 
making  a  total  of  $1,500;  leaving  a  cash  deficiency  of  $7,500. 
Putting  these  and  succeeding  calculations  into  tabular  form, 
they  would  be  as  follows : 


Cash  Deficiency 

Accumulating 

Outgo 

Receipts 

for  Month 

Deficiency 

First 

month 

$4,500 

$500 

$4,000 

$4,000 

Second 

9,000 

1,500 

7,500 

11,500 

Third 

13,500 

3,000 

10,500 

22,000 

Fourth 

18,000 

5,000 

13,000 

35,000 

Fifth 

18,000 

7,000 

11,000 

46,000 

Sixth 

18,000 

9,000 

9,000 

55,000 

Seventh 

18,000 

11,000 

7,000 

62,000 

Eighth 

18,000 

13,000 

5,000 

67,000 

Ninth 

18,000 

15,000 

3,000 

70,000 

Tenth 

18,000 

17,000 

1,000 

71,000 

Eleventh 

(( 

18,000 

18,500 

500* 

70,500 

Twelfth 

(( 
receipts. 

18,000 

19,500 

1,500* 

69,000 

♦Excess 

REQUIREMENTS   FOR  WORKING   CAPITAL 


403 


It  is  clear  from  the  above  table  that,  in  case  the  instalment 
seller  intends  to  carry  the  whole  burden  of  financing  on  his 
own  shoulders,  he  must  be  prepared  with  a  working  capital 
amounting  at  a  maximum  to  $7i,cxx).  Unless  his  business 
afterwards  increases  more  rapidly  than  his  cash  receipts,  he 
will  be  able  later  to  draw  large  profits  in  cash  which  are  the 
accumulated  results  of  sales  that  he  has  made  during  the  pre- 
ceding months. 

The  case  above  given  is  necessarily  crude,  for  within  the 
space  limits  that  can  be  assigned  to  the  subject  in  this  volume 
it  would  be  impossible  to  enter  into  all  the  intricacies  of  the 
calculations  that  would  be  required  in  any  actual  case.  The 
figures  presented,  however,  serve  to  emphasize  two  principles 
which  must  be  borne  in  mind  in  connection  with  all  instalment 
financing : 

1.  During  a  period  of  rapidly  increasing  business  the  cash 
receipts  cannot  keep  pace  with  the  volume  of  sales  and  the 
outgo.  Such  a  period,  therefore,  necessarily  involves  a  severe 
strain  on  the  financial  resources  of  the  instalment  house.  It 
is  for  this  reason  that  prosperity  and  large  sales  have  so  fre- 
quently been  the  direct  causes  of  financial  disaster  to  firms 
that  sell  goods  on  instalments. 

2.  Inasmuch  as  cash  receipts  pile  up  much  more  slowly 
than  sales,  the  first  stage  in  building  up  an  instalment  business 
is  a  stage  of  heavy  investment  and  of  patient  waiting.  No 
matter  what  profits  may  be  figured  on  the  volume  of  business 
that  is  being  done  at  this  stage,  it  is  evident  that  the  realization 
of  those  profits  in  cash  will  necessarily  be  deferred  to  a  later 
period.  This  preliminary  stage  may  last  for  several  years. 
After  the  business  becomes  fairly  stationary,  however,  cash 
receipts  from  preceding  sales  begin  to  accumulate  with  rapidity 
and  presently  the  financial  position  of  the  house  becomes  very 
strong. 

The  question  arising  in  connection  with  every  instalment 


404  INTERNAL   FINANCIAL   MANAGEMENT 

business,  therefore,  is :  what  can  be  done  to  shift  some  of  the 
financial  burden  of  building  up  the  business  from  its  own 
shoulders  to  the  shoulders  of  its  bankers  or  of  other  financial 
agencies?  Unless  this  problem  can  be  satisfactorily  solved, 
an  instalment  house  must  necessarily  be  limited  in  its  growth 
by  the  capital  that  can  be  contributed  by  those  directly  in- 
terested in  the  company.  The  problem  is  made  peculiarly 
difficult  by  the  fact,  to  which  allusion  has  previously  been 
made,  that  bankers,  as  a  rule,  have  not  been  favorably  impressed 
by  their  dealings  with  instalment  houses  and  are  not  inclined 
to  look  with  much  favor  on  propositions  to  aid  in  financing 
such  enterprises.  In  fact  it  may  be  said  that,  so  far  as  new 
enterprises  which  sell  on  the  instalment  plan  are  concerned, 
they  cannot  reasonably  hope  for  financial  assistance  from 
banks  until  after  their  business  has  become  well-established 
and  has  proved  itself  sound  and  profitable. 

Established  instalment  enterprises,  which  have  a  growing 
business  and  therefore  require  additional  financing,  are  or- 
dinarily able  to  obtain  the  temporary  advances  of  working 
capital  that  they  need  in  one  of  three  ways : 

1.  By  securing  a  large  line  of  credit  from  their  banks 

simply  on  the  strength  of  their  general  showing 
of  profits  and  their  accumulating  assets,  consisting 
of  instalment  accounts  receivable. 

2.  By  securing,   as   indicated  above,   notes   from  their 

purchasers.  Those  concerns  which  make  their  sales 
in  units  of  considerable  size  are  frequently  able  to 
discount  these  notes  or  to  place  them  as  collateral 
for  bank  loans  and  are  thus  able  to  finance  their 
requirements.  This  is  very  largely  done  by  firms 
which  sell  agricultural  machinery.  The  chief 
financial  strain  upon  them  is  largely  in  the  nature 
of  a  seasonable  strain  and  the  financial  help  which 


REQUIREMENTS   FOR  WORKING   CAPITAL         405 

they  require,  is,  therefore,  of  a  more  temporary 
nature  than  is  the  help  required  by  instalment 
houses  the  business  of  which  is  not  greatly  affected 
by  the  seasons. 
3.  By  making  arrangements,  not  with  a  bank,  but  with 
a  financing  company,  which  will  either  purchase 
their  instalment  accounts  or  instalment  notes  re- 
ceivable, or  will  make  advances  against  these 
accounts  or  notes  which  are  put  up  as  collateral. 

This  last  method  brings  us  to  the  subject  of  converting 
assets  into  cash,  which  is  treated  in  the  next  section. 

Converting  Working  Assets  into  Cash 

The  distinction  between  *'quick"  assets  and  "working" 
assets  has  already  been  noted  (Chapter  XVI).  We  can  go 
a  step  farther  and  make  a  like  distinction  between  cash  and 
other  quick  assets;  under  the  latter  classification  are  to  be 
included  accounts  and  notes  receivable  that  mature  within  a 
few  days  and  merchandise  which  is  already  sold  or  is  readily 
salable  for  cash.  The  only  asset  that  is  acceptable  in  settling 
bills  is  cash,  but  other  quick  assets  may  be  counted  as  almost 
equivalent  to  cash. 

Those  current  assets  which  are  convertible  inj;o  cash  only 
after  a  considerable  lapse  of  time  or  after  considerable  effort, 
belong  in  a  different  category.  It  is  dangerous  to  count  on 
them  as  if  they  were  cash,  for  numerous  contingencies  may 
interfere  with  their  being  converted  into  ready  cash  at  the 
time  that  has  been  anticipated.  Many  a  merchant  has  found 
himself  suddenly  face  to  face  with  bankruptcy  because  he 
counted  merchandise  on  his  shelves  as  if  it  were  already  sold 
and  later  found  it  to  be  unsalable ;  or  because  he  looked  upon 
accounts  receivable  on  his  books  as  if  they  were  already  col- 
lected and  later  found  that  some  of  his  important  customers 
were  themselves  embarrassed  or  were  "slow  pay."     It  is  be- 


4o6  INTERNAL   FINANCIAL   MANAGEMENT 

cause  these  contingencies  exist,  that  it  is  necessary  in  the 
prudent  management  of  most  business  concerns  to  maintain 
current  assets  at  an  aggregate  figure  considerably  exceeding 
current  liabilities.  In  manufacturing  concerns,  as  we  have 
seen,  the  current  assets  are  usually  regarded  as  normal  if  they 
are  125  to  133%  of  current  liabilities. 

The  more  readily  the  current  assets  of  a  corporation  are 
convertible  into  cash,  the  less  need  be  the  proportion  of  current 
assets  to  current  liabilities ;  or,  to  state  the  same  thing  in  other 
terms,  the  less  need  be  the  working  capital  of  the  concern. 
It  is  clear  that  if  working  assets  consist  exclusively  of  cash, 
all  the  requirements  of  safety  would  be  met  if  these  assets 
were  equal  to  the  current  liabilities.  In  other  words,  a  concern 
with  perfectly  liquid  working  assets,  need  have  no  working 
capital.  The  nearer  a  company  approaches  to  this  condition, 
the  smaller  is  its  requirement  of  working  capital;  conse- 
quently, it  follows  that  any  measures  which  can  be  taken  to 
increase  the  liquidity  of  such  assets  as  inventories  and  accounts 
receivable  will  make  possible  a  corresponding  saving  in  the 
sum  that  must  be  set  aside  for  working  capital. 

There  is  no  method  of  increasing  the  liquidity  of  stocks 
of  merchandise  except  care  in  manufacturing  or  in  purchasing 
only  stocks  that  are  readily  salable.  No  one  outside  the  busi- 
ness itself  can  be  of  much  assistance  in  securing  this  result. 
Accounts  receivable,  however,  constitute  an  asset  that  can  be 
transferred  and,  inasmuch  as  most  of  these  accounts  are  auto- 
matically at  some  later  date  converted  into  cash  they  furnish 
an  excellent  collateral  for  preliminary  advances  of  cash. 

Within  recent  years  a  large  business  has  been  built  up  by 
a  number  of  financing  corporations  which  make  it  their  chief 
business  to  make  advances  against  instalment  accounts  re- 
ceivable and  commercial  accounts  receivable,  thus  enabling  the 
firm  which  owns  such  accounts  to  convert  them  wholly  or 
partially  into  cash  before  they  have  come  to  maturity. 


REQUIREMENTS   FOR  WORKING   CAPITAL         407 

In  European  practice  financing"  corporations  of  this  type 
are  unknown  and  unnecessary,  for  most  sales  of  merchandise 
are  represented  by  accepted  drafts  (more  commonly  known 
as  "trade  acceptances")  which  the  selling  firm  may  discount 
at  its  own  bank  or  may  sell  in  the  open  market.  In  the  United 
States,  however,  the  custom  prevails  of  granting  ''lines  of 
credit"  at  banks;  these  lines  of  credit  are  based  in  large  part 
on  the  concerns'  showing  of  a  satisfactory  proportion  of  work- 
ing assets  to  current  liabilities  and  the  bank  does  not  favor 
any  method  of  anticipating  the  normal  conversion  of  current 
assets  into  cash  or  of  pledging  any  of  the  current  assets.  It 
has,  in  fact,  grown  to  be  an  accepted  principle,  which  many 
bankers  perhaps  fail  to  apply  with  sufficient  discretion,  that 
all  current  assets  must  be  kept  free  and  unincumbered ;  other- 
wise the  bank  will  not  care  to  extend  credit. 

In  spite  of  opposition  on  the  part  of  the  banks,  the  financ- 
ing corporations  have  rapidly  increased  the  volume  and  raised 
the  character  of  their  dealings.  Moreover,  certain  banks  and 
trust  companies  have  gradually  come  to  carry  on  a  limited 
amount  of  business  of  the  same  type. 

There  are  two  distinct  fields  of  operation  for  the  financing 
corporations  that  have  been  referred  to,  and  they  are  readily 
divisible  into  two  corresponding  groups  :  The  first  group  con- 
fines itself  almost  entirely  to  making  advances  against  instal- 
ment accounts  receivable,  and  the  second  group  into  making 
advances  against  commercial  accounts  receivable.  The  chief 
kinds  of  instalment  accounts  handled  in  this  manner  are  those 
which  arise  in  connection  with  the  sale  of  agricultural  ma- 
chinery, pianos,  and  other  musical  instruments.  Both  these 
lines  of  business  are  conducted  by  large  and  well-established 
corporations  which  do  a  national  business,  in  some  instances 
making  sales  direct  to  consumers  and  in  others  making  sales 
through  dealers  to  whom  they  frequently  give  assistance  in 
financing  their  business.     For  reasons  that  have  been  fully 


4o8  INTERNAL   FINANCIAL   MANAGEMENT 

explained  above,  the  amount  of  capital  that  would  be  required 
to  finance  an  instalment  business  of  any  size  would  be  prohibi- 
tive to  most  retail  dealers  if  they  were  to  work  unassisted. 
Publishing  companies  which  sell  dictionaries,  encyclopedias, 
and  other  sets  of  books,  payment  for  which  is  made  by  instal- 
ments, also  frequently  secure  advances,  using  their  accounts 
receivable  as  collateral;  for  various  reasons,  however,  this 
class  of  instalment  accounts  is  not  ordinarily  regarded  with 
so  much  favor  as  the  other  classes  that  have  been  mentioned. 
As  typical  of  the  manner  in  which  the  financing  corpora- 
tions that  handle  instalment  accounts  operate,  we  may  take  the 
published  description  issued  by  the  Commercial  Security  Com- 
pany of  New  York  and  Chicago,  which  makes  advances  on 
the  strength  of  notes,  mortgages,  and  leases  given  by  pur- 
chasers of  pianos  to  dealers  and  manufacturers.  The  company 
deals  only  with  concerns  which  furnish  satisfactory  financial 
statements  and  have  a  good  commercial  rating.  This  concern 
must  guarantee  all  the  instalment  accounts,  leases,  or  notes 
which  are  assigned  to  the  Commercial  Security  Company  as 
collateral.  The  accounts  (which  may  be  in  the  form  of  leases 
or  of  notes  secured  by  mortgages)  are  not  actually  taken  over 
by  the  Commercial  Security  Company,  but  are  left  in  charge 
of  some  one  in  the  employ  of  the  dealer  or  the  manufacturer 
who  is  authorized  to  make  collections  and  who  is  bonded  to 
make  prompt  payment  of  the  proceeds  to  the  Security  Com- 
pany; the  former  custom  of  transferring  the  accounts  bodily 
to  the  financing  corporation  which  made  its  own  collection  has 
proved  objectionable  and  has  been  almost  entirely  abandoned. 
The  Commercial  Security  Company  requires  that  final  instal- 
ments on  the  paper  which  it  accepts  as  collateral  must  mature 
within  31  months,  and  that  at  least  20%  of  the  price  of  the 
piano  must  have  been  paid,  leaving  80%  of  the  price  to  be 
collected.  Against  this  balance  the  Commercial  Security  Com- 
pany makes  advances  to  the  extent  of  80% ;  in  other  words. 


REQUIREMENTS   FOR  WORKING   CAPITAL         409 

the  maximum  advances  are  equivalent  to  64%.  of  the  retail 
price  of  the  pianos.  The  Commercial  Security  Company  then 
deposits  the  paper  which  it  has  accepted  as  collateral,  with 
certain  designated  trust  companies  in  New  York  and  Chicago, 
and  issues  its  own  6%  bonds  up  to  80%  of  the  face  value  of 
the  paper  which  it  has  deposited.  These  bonds  (which  might 
better  be  called  ''serial  notes")  are  issued  in  series  of  $100,000, 
$10,000  maturing  every  three  months,  so  that  each  issue  is 
paid  out  within  2^  years.  The  bonds  are  sold  to  banks  and 
to  the  general  public,  and  are  said  to  be  well  regarded  as  a 
good  type  of  short-terms  notes. 

The  Agricultural  Credit  Company,  which  was  incorporated 
in  New  York  in  19 12,  operates  along  much  the  same  lines, 
except  that  it  specializes  in  the  notes  or  other  obligations  given 
in  payment  for  agricultural  implements.  A  number  of  other 
companies  might  be  mentioned. 

In  making  advances  on  commercial  accounts  receivable, 
the  Manufacturers'  Commercial  Company  of  New  York  fol- 
lows much  the  same  plan  that  has  just  been  described.  This 
company  purchases  the  accounts  receivable  of  mercantile  firms 
and  deposits  the  paper  which  it  purchases  with  a  trust  com- 
pany as  collateral  for  its  own  issues  of  collateral  trust  certifi- 
cates. These  certificates  bear  5%  interest,  maturing  in  from 
30  days  to  one  year,  and  are  in  amounts  of  $100  or  any 
multiple  thereof.  They  are  sold  both  to  banks  and  to  private 
investors.  The  company  carries  a  20%  margin  of  collateral. 
On  April  i,  19 14,  according  to  the  company's  published  state- 
ment, the  total  collateral  held  by  the  trust  was  in  excess  of 
$800,000  based  on  i  ,073  accounts,  showing  an  average  amount 
of  $795.22  in  each  account.  The  company  features  the  wide- 
spread distribution  of  risk  due  to  the  small  sum  represented 
by  each  account.  Most  of  the  financing  corporations,  however, 
which  handle  commercial  accounts  receivable,  themselves  re- 
assign the  paper  which  they  take  over,  with  their  own  indorse- 


4IO 


INTERNAL   FINANCIAL   MANAGEMENT 


ment,  to  the  banks  with  which  they  do  business.  They  make 
a  point  of  the  fact  that  accounts  or  notes  can  be  assigned  and 
yet  the  collections  may  remain  in  the  hands  of  their  clients, 
thus  insuring  that  the  assignment  is  kept  confidential. 

The  Commercial  Credit  Company  of  Baltimore  advertises 
that  manufacturers  and  jobbers  may  sell  to  them  $200,000 
of  notes  during  any  year,  at  a  total  cost  of  $2,500,  provided 
they  are  paid  within  30  days.  Inasmuch  as  this  is  at  the  rate  of 
1%  per  month,  plus  a  commission  charge  of  ^%  on  the  first 
$100,000  of  accounts,  it  is  clear  that  the  rate  of  discount  which 
the  manufacturer  or  jobber  must  pay  is  high;  yet  the  accom- 
modation that  he  receives  may  be  well  worth  the  discount. 

These  companies  usually  loan  up  to  about  75  to  80%  of 
the  face  value  of  the  paper  which  they  accept  as  collateral. 
Sometimes  a  fixed  line  of  credit  is  granted  to  a  client,  against 
which  a  corresponding  amount  of  collateral  is  constantly  main- 
tained (paid  or  bad  accounts  being  continually  replaced  by 
fresh  ones),  and  sometimes  a  separate  loan  is  made  against 
each  given  block  of  collateral,  each  loan  being  regarded  as  a 
new  and  distinct  transaction. 

An  Unusual  Problem 

The  special  problem  that  we  have  just  been  considering — 
the  problem  of  converting  current  assets  into  cash — comes  up 
in  nearly  all  lines  of  business,  and  in  many  different  forms. 
While  it  is  not  necessary  to  consider  all  possible  variations, 
one  problem  in  this  field  which  is  somewhat  peculiar  and 
which  is  also  illuminating,  may  be  described.  The  problem 
can  best  be  stated  in  the  words  of  the  man  who  is  facing  it : 

I  am  engaged  in  a  paving  contract  for  the  city  of 
....  payment  for  which  is  given  to  me,  not  in  cash,  but 
in  special  tax  bills  issued  against  the  property  along  the 
streets  that  are  being  paved.  These  tax  bills  are  evidence 
that  an  assessment  has  been  levied  against  the  property. 


REQUIREMENTS   FOR  WORKING   CAPITAL         ^n 

They  are  delivered  to  the  contractor  who  may  make  his 
own  collections  on  certain  conditions;  or  the  tax  may  be 
paid  to  the  City  Treasurer  who  will  transmit  it  to  the 
owner  of  the  tax  bills.  The  bills  bear  7%  interest  after 
maturity.  In  case  of  non-payment,  the  owner  of  these 
tax  bills  must,  at  his  own  expense,  bring  suit  within  two 
years  and,  inasmuch  as  the  tax  bills  take  precedence  over 
everything  except  general  state,  city,  and  county  taxes, 
may  readily  enforce  collection.  However,  suit  cannot 
profitably  be  instituted  until  toward  the  end  of  the  second 
year,  and  many  property  owners  who  are  aware  of  this 
fact  allow  them  to  run  throughout  nearly  the  whole 
period.  The  average  length  of  time  before  the  tax  bills 
are  paid  is  about  five  months. 

These  tax  bills  are  not  readily  salable  either  to  bankers 
or  to  investors;  although  they  are  exceptionally  well 
secured  and  draw  7%  interest,  the  time  of  payment  is 
so  uncertain  that  no  one  desires  to  have  his  money  tied 
up  in  them  unless  he  is  compensated  by  an  exceptionally 
heavy  discount,  which  usually  amounts  to  10%. 

On  the  other  hand,  in  my  contracting  business  I  need 
to  turn  over  capital  quickly,  and  find  that  tying  up 
money  in  these  slow  bills  cripples  my  capacity  to  handle 
work. 

Here  is  a  problem  that  is  unusually  difficult  because  of  the 
non-commercial  character  of  these  tax  bills,  and  also  because 
of  their  uncertain  maturity.  It  was  suggested  that  the  only 
solution  in  this  case  is  to  use  the  tax  bills  as  collateral  for 
notes  either  to  be  discounted  at  banks  or  to  be  sold  to  private 
investors.  It  would  be  necessary  that  the  arrangement  as  to 
collateral  should  be  sufficiently  elastic  so  that  as  rapidly  as 
some  of  the  bills  were  paid  off,  others  would  be  substituted. 
The  contractor  would  then  be  able  to  give  his  personal  notes 
of  a  definite  date  of  maturity  and,  in  case  the  tax  bills  were 
not  paid  with  sufficient  promptitude  to  meet  the  notes,  he 
would  then  have  left  the  recourse  of  selling  the  remaining 
tax  bills  at  a  heavy  discount,  thus  enabling  him  to  take  care 


412 


INTERNAL    FINANCIAL   MANAGEMENT 


of  his  own  notes.  At  the  worst,  this  method  should  be  less 
expensive  than  the  usual  method  of  selling  the  notes  outright. 
Unless  there  were  some  unexpected  failure  on  the  part  of  a 
number  of  taxpayers  to  meet  their  obligations,  the  contractor 
would  probably  be  able  to  borrow  funds  required  in  his  busi- 
ness at  no  more  than  the  usual  bank  discount  rates.  It  is 
understood  that  this  suggested  course  of  action  has  been  fol- 
lowed and  that  by  this  method  of  converting  some  of  his 
current  accounts  into  cash  the  contractor  has  been  able  to 
proceed  with  the  normal  development  of  his  business. 

Working  Capital  to  Provide  for  Seasonal  Variations 

A  great  many  companies  work  under  the  handicap  of 
extreme  variations  in  the  amount  or  the  character  of  their 
business  from  one  season  to  another.  This  was  formerly 
true,  for  example,  in  the  automobile  business.  During  the 
early  period  of  the  popularity  of  pleasure  vehicles  the  great 
mass  of  sales  were  made  in  the  spring  and  early  summer  of 
each  year;  it  is  reported  that  in  this  industry  the  seasonal 
variation  is  being  much  reduced.  Manufacturers  of  rubber 
goods,  especially  rubber  shoes,  find  their  sales  concentrated 
at  certain  seasons;  the  same  thing  is  true  of  manufacturers 
of  agricultural  implements,  of  sporting  goods,  and  of  many 
other  products  that  will  readily  occur  to  every  one.  Manu- 
facturers of  textiles,  of  beet  sugar,  and  of  other  products 
made  from  raw  materials  gathered  from  the  soil  are  under 
the  necessity  of  buying  heavily  at  certain  seasons  of  the  year 
in  order  to  secure  the  benefit  of  minimum  prices.  In  all  these 
lines  of  industry,  either  large  stocks  of  finished  products  must 
be  accumulated  during  the  remainder  of  the  year  in  order  to 
meet  the  requirements  of  the  busy  season,  or  large  stocks  of 
raw  materials  must  be  purchased  at  a  given  season  and  grad- 
ually used  up  during  the  remainder  of  the  year.  In  either 
case  it  is  clear  that  much  larger  sums  of  money  must  be  tied 


REQUIREMENTS   FOR  WORKING   CAPITAL         413 

up  in  working  assets  during  certain  periods  than  during  other 
periods  of  the  year.  This  is  a  situation  that  involves  unusual 
difficulties  and  greatly  affects  the  amount  of  working  capital 
that  is  required.  The  usual  method  is  to  secure  a  gradually 
increasing  amount  of  bank  loans  as  finished  products  are  ac- 
cumulated which  are  rapidly  paid  off  during  the  sales  season; 
or,  if  the  other  situation  prevails,  a  large  loan  is  effected  dur- 
ing the  buying  season  which  is  gradually  paid  off  during  the 
remainder  of  the  year.  Dependence  upon  bank  loans  exclu- 
sively, however,  is  unsafe,  as  many  companies  have  discovered. 
Textile  manufacturing  companies  have  been  peculiarly  subject 
to  failure  because  of  their  inability,  owing  to  some  unforeseen 
contingency,  to  meet  the  obligations  held  by  their  banks.  Some 
years  ago,  when  the  so-called  ** Sugar  Trust"  desired  to  obtain 
control  of  an  important  beet  sugar  refinery,  it  is  alleged  to 
have  obtained  this  result  by  secretly  buying  up  all  the  short- 
time  notes  given  by  the  sugar  refinery  during  its  purchasing 
season  and  then  demanding  prompt  payment  of  these  notes 
instead  of  granting  the  customary  partial  renewals.  As  a 
result,  the  prosperous  refinery  suddenly  found  itself  confronted 
with  the  prospect  of  bankruptcy  and  was  forced  to  surrender. 
Although  it  would  not  be  economical  for  companies  en- 
gaged in  seasonal  industries  to  keep  themselves  supplied  with 
the  amount  of  working  capital  that  is  required  at  the  maximum 
period  of  each  year,  it  is  highly  desirable  and  prudent  that 
they  should  carry  a  much  larger  working  capital  than  would 
be  required  during  the  off  seasons.  This  is  a  part  of  their 
normal  expense  of  doing  business.  Such  companies  some- 
times find  it  advantageous  to  invest  their  surplus  cash  reserves 
during  the  off  seasons  in  short-term  securities. 

Month-by-Month  Calculations 

It  was  remarked  at  the  beginning  of  this  chapter  that  it 
would  be  impracticable  to  attempt  to  draw  up  any  invariable 


414 


INTERNAL   FINANCIAL   MANAGEMENT 


formula  for  calculating  the  amount  of  working  capital  required 
in  any  given  concern.  We  must  content  ourselves  with  the 
general  statement  that  working  capital  requirements  vary 
roughly  in  proportion  to  the  volume  of  business,  the  length  of 
period  of  manufacture,  the  average  length  of  credit  extended 
to  customers,  and  the  extent  of  seasonal  variations  in  volume 
of  business,  and  that  they  vary  roughly  in  inverse  proportion 
to  the  rapidity  of  turnover,  length  of  credit  obtained  in 
purchases  of  goods,  and  the  facilities  available  for  converting 
current  assets  into  cash.  These  are  the  factors  to  be  taken  into 
account. 

Inasmuch  as  the  customary  unit  of  time  used  in  reckoning 
most  commercial  operations  is  the  month,  it  is  worth  while, 
in  all  close  thinking  and  figuring  as  to  the  working  capital 
requirements,  to  make  estimates  on  a  month-to-month  basis. 
An  estimate  of  this  nature  relating  to  a  hypothetical  case  of 
a  house  doing  an  instalment  business  has  already  been  given 
and  will  serve  as  an  illustration  of  the  method  that  should  be 
followed  in  making  up  all  such  estimates.  If  all  the  factors 
that  have  just  been  named  are  known,  and  assuming  in  addi- 
tion that  the  various  costs  of  manufacture  or  of  purchase, 
selling,  overhead  administration,  and  the  like  are  known,  there 
will  be  no  difficulty  in  figuring  out  just  what  the  cash  outgo 
and  cash  receipts  of  each  month  will  amount  to.  This  will 
show  the  working  capital  requirements  month  by  month.  By 
adding  a  liberal  margin  to  cover  faulty  estimates  and  contin- 
gencies, the  approximate  amount  of  working  capital  required, 
even  for  a  new  corporation,  can  be  estimated.  In  the  case  of 
an  established  corporation,  which  has  behind  it  years  of  experi- 
ence and  of  records,  the  information  that  is  desired  can  be 
worked  out  with  greater  accuracy. 


CHAPTER    XVIII 

DETERMINATION    OF    NET    INCOME 

Formula  for  Income 

The  chapters  preceding  have  dealt  with  such  subjects  as 
the  financial  forms  of  business  enterprises,  the  various  types 
of  shares  and  of  obligations  that  may  be  issued,  the  selection 
of  securities  that  are  adapted  to  all  the  needs  of  the  corporation 
and  to  the  security  market,  the  construction  of  a  correct 
financial  plan,  the  promotion  and  initial  financing  of  a  new 
enterprise,  the  various  methods  of  selling  securities  and  thus 
raising  the  capital  required,  and  the  principles  which  determine 
the  investment  of  that  capital  in  fixed  and  in  working  assets. 
This  completes  our  study  of  the  various  stages  in  the  creation 
and  financial  organization  of  a  concern.  The  remaining  chap- 
ters deal  with  the  management  of  companies  that  are  already 
established  and  with  the  exploitation  and  reorganization  of 
companies  that  are  unfortunate  or  mismanaged. 

The  first  questions  that  arise  in  the  financial  management 
of  a  going,  profit-making  concern  have  to  do  with  the  de- 
termination and  distribution  of  its  income.  The  determination 
of  income  may  be  regarded  as  primarily  a  problem  of  account- 
ing, but  it  is  also  a  financial  problem.  As  was  pointed  out  in 
Chapter  I,  the  line  of  distinction  between  financial  and 
accounting  questions  is  not  always  to  be  sharply  drawn.  We 
will  not  be  trespassing,  then,  on  the  exclusive  territory  of  our 
friends,  the  accountants,  if  we  take  up  for  brief  review  the 
question  of  how  corporate  income  is  and  should  be  determined. 

For  purposes  of  illustration  the  following  two  statements 
of  income  are  reproduced.  The  first  from  a  recent  report 
of  the  American  Locomotive  Company  is  in  the  following 
form : 

415 


4i6  INTERNAL   FINANCIAL   MANAGEMENT 

Gross  Income $29,987,438 

Operating  Expenses,  Including  Manufacture,  Mainte- 
nance, and  Administrative  Expenses  and  Depreciation 
Charge 27,425,187 

Net  Income $2,562,251 

Interest,  Taxes,  and  Other  Fixed  Charges  486,124 

Surplus  for  the  Year $2,076,127 

Preferred  Dividends 1,750,000 

Surplus  Available  as  Earnings  on  Common  Stock $326,127 

Equivalent  on  Common  Stock  to i-3% 

Dividends  on  Common  Stock 

Carried  to  Surplus  Account  $326,127 


A  much  more  detailed  income  statement  is  that  of  the 
Union  Pacific  Railroad  Company,  which  is  as  follows: 

Freight  Revenue   $59,253,344 

Passenger  Revenue  18,817,047 

Mail,  Express,  and  All  Other  Transportation  Revenue. . .  6,726,317 

Incidental  Revenue  2,161,587 

Total  Revenue  $86,958,295 

Maintenance  of  Way  and  Structures $10,900,925 

Maintenance  of  Equipment  12,101,212 

Total  Maintenance  $23,002,137 

Traffic    Expenses 2,061,971 

Transportation  Expenses 23,108,140 

Miscellaneous  Operations  Expenses  1,313,189 

General  Expenses   2,811,421 

Transportation  for  Investment — credit 160,lJf3 

Total  Operating  Expenses $52,136,715 

Taxes 4,641,474 

Total  Operating  Expenses  and  Taxes $56,778,189 


DETERMINATION    OF   NET    INCOME  417 

Revenues  Over  Operating  Expenses  and  Taxes $30,180,106 

Other  Operating  Income  1,276,138 

Total  Operating  Income   $31,456,244 

Fixed  and  Other  Charges  15,028,285 

Surplus  from  Transportation  Operations  After  Deduct- 
ing all  Fixed  and  Other  Charges $16,427,959 

Income  from  Investments  and  Other  Sources 11,964,064 

Total  Surplus  $28,392,023 

Less  Dividend  on  Preferred  Stock  at  4%  Per  Annum 3,981,740 

Surplus  After  Deducting  Dividend  on  Preferred  Stock.  .  $24,410,283 

Equivalent  on  Common  Stock  to 10.98% 

Amount  Required  to  Pay  Dividend  on  Common  Stock  at 

Rate  of  8%  Per  Annum $17,783,328 


Surplus  After  Deducting  all  Fixed  and  Other  Charges 
and  Dividends  on  Preferred  and  Common  Stock $6,626,955 


The  above  examples  show  the  essential  steps  in  calculating 
income,  which  are  as  follows : 

1.  State  gross  earnings. 

2.  Deduct  operating  or  manufacturing  expenses,  includ- 

ing selling,   administrative,   maintenance,   and   de- 
preciation. 

3.  The  result  is  net  earnings  from  operation. 

4.  Add  income  from  other  sources. 

5.  The  result  is  total  net  income. 

6.  Deduct  taxes,  interest,  rentals,  sinking  fund  charges, 

and  other  fixed  charges. 

7.  The  result  is  surplus  for  the  year  applicable  as  earn- 

ings on  shareholdings. 

8.  Deduct  preferred  dividends. 


4i8  INTERNAL   FINANCIAL   MANAGEMENT 

9.    Deduct  common  dividends. 

10.    The  result  is  surplus  from  the  year's  operations  to  be 
credited  to  surplus  account. 

It  seems  hardly  worth  while  to  point  out  that  income  and 
expenditure  are  by  no  means  identical  with  cash  receipts  and 
cash  disbursements,  though  this  elementary  distinction  is  not 
always  grasj>ed,  even  by  learned  judges  and  lawyers.  It  has 
been  pointed  out,  for  instance,  by  an  English  authority,  that 
among  the  legal  judgments  which  have  been  delivered  in  the 
courts  of  the  United  Kingdom  are  such  absurdities  as  the 
following :  * 

Profits  for  the  year,  of  course,  mean  the  surplus  in 
receipts  after  paying  expenses  and  restoring  the  capital 
to  the  position  it  was  in  on  the  ist  of  January  in  that 
year. 

Fixed  capital  may  be  sunk  and  lost  and  yet  the  excess 
of  current  receipts  over  current  expenses  may  be  applied 
in  payment  of  a  dividend. 

It  has  been  only  a  few  years  since  the  Attorney-General 
of  the  United  States  interpreted  the  law  imposing  a  tax  on 
corporate  income,  which  had  just  been  passed  by  Congress, 
as  meaning  that  a  tax  had  been  imposed  on  the  cash  receipts 
minus  cash  disbursements.  His  decision  was  promptly  over- 
ruled, but  among  accountants  it  has  not  been  forgotten. 

Honesty  in  Stating  Gross  Earnings 

In  connection  with  the  preceding  paragraph,  it  must  be 
admitted,  however,  that  the  conception  of  the  word  income 
as  referring  only  to  net  cash  receipts,  has  the  advantage  of 
being  much  simpler  than  the  present  significance  of  the  word. 
Income  as  understood  in  modern  business  includes  all  the 
various  kinds  of  realized  gain  from  operations  during  a  given 
period.     This  gain  may  be  realized  in  the  form  of  increased 


*  Francis  W.  Pixley,  "Auditors:  Tkeir  Duties  and  Responsibilities,"  pp.  515-517, 


I 


DETERMINATION   OF  NET   INCOME 


419 


accounts  receivable,  enlarged  facilities  for  production,  reduced 
obligations,  or  in  various  other  ways.  Inasmuch  as  the  ex- 
tent of  the  gain  is  frequently  difficult  to  measure,  there  is 
left  considerable  latitude  for  the  exercise  of  discretion  and 
good  faith  on  the  part  of  officials  in  estimating  income.  It 
is  sometimes  possible  for  them,  if  they  are  not  governed  by 
the  strictest  integrity,  to  stretch  or  reduce  the  statement  of 
income  which  they  give  to  their  stockholders  and  to  the  pub- 
lic in  order  to  serve  their  personal  interests. 

In  the  first  report  of  the  United  States  Realty  and  Con- 
struction Company,  earnings  for  the  nine  months'  period  ended 
June  30,  1903,  were  given  as  $1,417,000;  but  it  later  appeared 
that  $487,000  of  these  earnings  consisted  of  "profits  from 
estimated  increase  in  the  value  of  investments  still  held"  and 
$577,000  consisted  of  "profit  on  buildings  In  progress,  esti- 
mated proportion  accrued."  The  first  Item  Is  typical  of  a 
practice  that  is  frequently  advocated  by  corporate  officials 
who  desire  to  make  a  showing  of  profits  that  have  not  been 
earned  through  operation.  Real  estate,  securities,  stocks  of 
merchandise,  and  the  like  are  constantly  fluctuating  In  value. 
If  any  of  these  properties  is  actually  sold  and  a  profit  is  real- 
ized. It  is  entirely  proper  that  this  profit  should  be  credited 
to  surplus,  but  it  should  certainly  not  be  credited  to  the  sur- 
plus arising  out  of  operations  during  a  given  period.  So 
long  as  the  profit  is  not  realized,  but  exists  simply  on  paper, 
it  is  almost  universally  agreed  that  It  should  not  be  credited 
at  all.  Officers  who  advocate  marking  up  profits  on  account 
of  fluctuations  in  value  of  permanent  holdings  are  frequently 
the  first  ones  to  find  some  plausible  reason  for  declining  to 
mark  down  profits  when  these  same  holdings  decline  In  value. 
If  a  company  Is  engaged  in  the  business  of  buying  and  selling 
real  estate  or  securities,  the  case  may  be  different  and  may 
be  worthy  of  further  consideration,  but  In  other  cases  such 
profits  should  not  be  credited  unless  realized. 


420 


INTERNAL   FINANCIAL   MANAGEMENT 


As  to  the  second  item,  there  is  undoubtedly  more  room  for 
debate.  It  would  seem  unfair  that  companies  which  cus- 
tomarily engage  in  long-time  contracts,  such  as  the  construc- 
tion of  buildings  and  the  like,  should  credit  no  profits  to  the 
period  in  which  the  construction  work  is  going  on.  On  the 
other  hand,  it  was  found  in  the  case  of  the  United  States 
Shipbuilding  Company  that  the  anticipated  profits  on  large 
contracts,  which  had  been  counted  in  the  millions  of  dollars, 
were  never  realized,  but  actually  turned  into  a  loss  at  the 
completion  of  the  contracts.  Estimates  of  profits  on  un- 
completed contracts  are  likely  to  be  made  by  officers  whose 
judgment  may  be  warped  by  their  own  interests.  Such  items 
are  to  be  considered,  therefore,  with  some  degree  of  skepticism. 

A  curious  difficulty  of  accounting  in  arriving  at  gross 
profits  is  illustrated  in  the  financial  history  of  the  American 
Malting  Company.  It  appears  that  in  the  malting  process 
each  bushel  of  cleaned  barley  produces  112  to  115%  of  a 
bushel  of  malt.  This  increase  is  a  normal  incident  in  the 
process  of  manufacturing  malt  and  it  is  claimed  should  be 
taken  into  consideration  as  a  source  of  profits.  It  is,  how- 
ever, at  least  questionable  whether  anticipated  profits  from 
this  source  should  be  counted.  It  probably  is  time  enough  to 
count  them  when  the  profits  have  actually  been  realized. 

Another  fruitful  source  of  error  in  stating  gross  earnings 
is  overoptimism  in  the  valuation  of  finished  and  partly 
finished  products  and  raw  materials  on  hand.  Sometimes  bal- 
ance sheets  are  found  in  which  inventories  amount  to  several 
times  the  aggregate  of  gross  sales.  In  such  cases  it  is  clear 
that  even  a  slight  excess  valuation  of  the  inventories  may  be 
the  real  source  of  a  considerable  proportion  of  the  alleged 
profits.  Where  the  item  of  inventories  appears  to  be  con- 
stantly growing,  from  year  to  year,  more  rapidly  than  sales 
and  profits,  the  estimate  of  gross  earnings  should  certainly 
be  subjected  to  close  examination. 


DETERMINATION   OF  NET   INCOME  421 

At  the  formation  of  the  American  Bicycle  Company  in 
1898,  the  constituent  plants  were  taken  in  largely  on  the  basis 
of  their  reported  net  earnings.  From  later  developments 
and  analysis  it  seems  probable  that  these  net  earnings  were 
in  many  cases  overstated,  by  reason  of  the  fact  that  inventories 
of  dead  stock  which  should  have  been  charged  off  to  profit 
and  loss  were  carried  at  their  full  valuation.* 

It  should  never  be  forgotten  that,  by  reason  of  the  dis- 
cretion which  is  necessarily  accorded  to  them  in  estimating 
gross  earnings,  corporate  officials  ought  to  be  exceptionally 
conservative,  and  for  their  own  protection  should  rely  to  a 
great  extent  upon  the  judgment  of  impartial  accountants  and 
other  outside  advisers.  Misstatements  of  gross  earnings  are 
not  made  necessarily  with  dishonest  intentions;  the  men  who 
are  most  interested  in  the  business  are  frequently  the  very 
ones  who  are  most  easily  persuaded  that  an  exaggerated  esti- 
mate of  unrealized  earnings  is  sound  and  reliable. 

Operating  Expenses  and  Deductions 

There  is  usually  little  question  as  to  the  actual  outgo  for 
raw  materials  or  other  purchases,  labor,  selling  expenses, 
salaries  of  officers  and  other  administrative  overhead,  etc.,  all 
of  which  are  directly  chargeable  to  the  various  accounts  that 
are  grouped  under  the  general  heading  of  "Operating  Ex- 
penses.'' Even  here,  claims  are  sometimes  advanced  in  favor 
of  charging  such  expenditures  as  for  advertising  and  for 
training  employees,  to  capital  accounts  rather  than  to  operating 
expenses,  on  the  theory  that  such  expenditures  are  a  permanent 
benefit  to  the  business.  If  such  claims  are  to  be  allowed  at  all, 
which  is  usually  doubtful,  it  is  regarded  as  correct  practice  to 
charge  items  of  this  nature  to  some  such  account  as  "Deferred 
Expenses,"  which  is  carried  on  the  balance  sheet  for  the  time 


•The    illustrations    in    this    section   are,    for    the   most   part,   taken    from    Dewing's 
'Corporate    Promotions    and    Reorganizations." 


422 


INTERNAL   FINANCIAL   MANAGEMENT 


being  as  a  capital  account  but  is  intended  to  be  written  off 
within  a  brief  period. 

There  is  Httle,  if  any,  question  also  as  to  most  expenditures 
for  repair  and  maintenance  of  the  permanent  property  of  the 
business.  This  property  must  be  kept  up  as  nearly  as  possible 
to  its  original  standard  of  efficiency,  and  the  expense  of  so 
doing  can  scarcely  be  regarded  otherwise  than  as  a  portion  of 
the  total  expense  of  operation.  Going  a  step  farther,  it  is  well 
to  point  out  that  many  new  companies  make  a  serious  error  in 
that  they  do  not  at  once  begin  to  charge  against  profits  a  fair 
allowance  which  will  take  care  of  at  least  a  portion  of  the 
repairs  and  other  maintenance  expenses  that  are  to  be  expected 
in  the  course  of  a  few  years.  Owners  of  apartment  houses 
and  other  city  real  estate  are  frequently  negligent  in  this 
respect  to  their  own  detriment.  A  building  of  this  character 
may  run  for  some  years  with  comparatively  slight  outlay  for 
repairs;  then  all  at  once  everything  is  out  of  order.  Either 
large  sums  must  be  expended  and  charged  against  operating 
expenses  or  the  character  of  the  building  will  change  for  the 
worse  and  a  lower  income  will  be  obtained.  The  same  line 
of  reasoning  applies  to  many  manufacturing  establishments. 
Electric  railways  up  to  the  present  time  have  not,  on  an 
average,  consumed  nearly  so  large  a  ratio  of  their  gross  earn- 
ings in  maintenance  as  do  steam  lines.  Whether  the  ratio  will 
later  become  larger  is  an  undecided  question,  but  perhaps  it 
may  reasonably  be  assumed  that  it  will  increase.  Unless 
provision  is  made  in  advance,  the  results  cannot  be  pleasing 
to  shareholders  in  such  companies.  The  subject  of  main- 
tenance and  repairs  will  be  again  referred  to  a  little  farther 
on  in  this  chapter. 

Reserves 

Nearly  all  well-managed  corporations  charge  against  the 
profits  of  each  year  an  estimated  sum,  or  a  number  of  distinct 


DETERMINATION   OF   NET    INCOME 


423 


estimated  sums,  which  are  intended  to  provide  for  losses  and 
expenses  that  will  probably  arise  In  the  future  but  which  are 
incident  to  the  operations  of  the  current  period.  The  sums 
so  charged  are  credited  to  reserve  accounts,  which  are  carried 
on  the  balance  sheet  of  the  company.  As  to  the  nature  and  use 
of  these  reserve  accounts,  there  is  much  misunderstanding. 
They  do  not  consist,  as  people  seem  sometimes  to  imagine,  of 
funds  of  cash  or  property  set  aside  for  the  purpose  of  meeting 
future  expenses.  It  is,  in  fact,  easily  possible  that  a  company 
may  accumulate  large  reserve  accounts  and  yet  be  quite  unable 
to  meet  the  anticipated  expenses  when  they  actually  arise. 
The  essential  character  of  all  reserves  lies  in  the  fact  that  they 
constitute  a  deduction  from  profits.  The  reserves  exist  only 
in  the  form  of  entries  and  figures  in  the  company's  books  of 
account.  It  is  quite  possible  that  a  firm  which  carries  no 
reserves  on  its  balance  sheet  may  be  just  as  conservatively 
managed  as  the  one  which  has  large  reserves.  But  the  proba- 
bilities are  the  other  way,  for  the  reason  that  proper  estimates 
in  favor  of  reserve  accounts  assist  the  officers  and  stockholders 
of  a  company  in  gauging  the  true  status  of  the  business  and 
therefore  discredit  exaggerated  optimism. 

The  most  common  form  of  reserve  is  that  for  depreciation 
in  the  value  of  fixed  assets,  due  to  wear  and  tear,  obsolescence, 
etc.  Depreciation  on  account  of  wear  and  tear  may  be  esti- 
mated in  advance  with  some  accuracy,  but  depreciation  for 
obsolescence  is  always  of  uncertain  amount.  No  one  can 
foresee  what  changes  in  taste  or  fashion,  what  unthought-of 
inventions,  or  what  improvements  in  organization  may  take 
place,  which  will  perhaps  render  useless,  or  partly  useless, 
much  of  the  company's  plant,  machinery,  or  other  assets.  The 
best  that  can  be  done  is  to  make  a  fairly  liberal  estimate,  based 
on  the  experience  of  the  past  and  trust  that  it  will  be  sufficient 
to  keep  the  book  value  of  fixed  assets  always  well  within  the 
limits  of  actual  value.    If  this* result  is  not  accompHshed,  then 


424 


INTERNAL   FINANCIAL   MANAGEMENT 


the  depreciation  reserve  is  insufficient  and  net  income  is  over- 
stated. 

Although  the  presence  of  depreciation  as  an  actual  factor 
in  every  business  can  scarcely  be  denied,  yet  the  absence  of 
any  depreciation  charges  and  reserve  accounts  on  the  books 
of  certain  corporations  is  defended  by  fallacious  arguments. 
For  example,  many  street  railway  companies  and  other  public 
utility  corporations  decline  to  make  any  deduction  for  depre- 
ciation charges  from  gross  income.  The  claim  which  many  of 
them  advance  is  that  the  value  of  their  franchises  is  constantly 
increasing  and  is  sufficient  to  offset  the  admitted  decline  in 
value  of  their  road-bed  and  equipment.  This  kind  of  argument 
is  apparently  advanced  simply  to  justify  a  line  of  action  pre- 
viously determined  upon.  It  is  based  upon  a  two-fold  fallacy. 
First  of  all,  granting  that  there  is  a  steady  rise  in  the  value  of 
the  company's  franchises  and  that  this  rise  should  be  taken 
into  the  income  account,  it  should  then  be  valued  by  itself  and 
shown  as  a  source  of  income,  w^hile  depreciation  charges  should 
be  shown  as  a  deduction  from  income;  otherwise  there  is  not 
even  an  attempt  to  make  up  a  fair  and  reliable  income  state- 
ment. In  the  second  place,  experience  has  by  this  time  shown 
that  the  alleged  increase  in  the  value  of  franchises  is  a  highly 
uncertain  factor.  Most  public  utility  enterprises  are  subject 
in  a  peculiar  degree  to  legislative  control  and  the  legislature 
usually  takes  care  that  franchise  values  are  not  permitted  to 
increase  with  excessive  rapidity.  The  better  managed  public 
utility  companies  are  gradually  falling  into  line  and  are 
forming  adequate  depreciation  reserves. 

Another  fallacy  is  clearly  seen  from  the  last  annual  report 
of  the  Canadian  Locomotive  Company,  which  includes  this 
remarkable  assertion:  "We  have  not  added  anything  to  de- 
preciation reserve  account  as  we  feel  that,  our  plant  being 
new,  the  $75,000  already  at  the  credit  of  this  account  is  suf- 
ficient.'* • 


DETERMINATION    OF   NET    INCOME 


425 


Following  out  the  line  of  reasoning  of  the  directors  of 
this  company,  it  is  evident  that  depreciation  reserves  are  to 
be  set  aside  only  v^hen  the  period  has  arrived  in  which  they 
are  actually  needed.  This  makes  the  so-called  depreciation 
reserve  and  the  account  for  repairs  and  maintenance,  practically 
identical,  and  does  away  with  the  only  genuine  reason  for  the 
creation  of  a  depreciation  reserve.  The  London  Economist 
has  put  the  truth  of  the  situation  clearly  in  the  following 
words :  "Depreciation  allowances  are  all  the  more  necessary 
in  a  boom  period,  because  there  is  always  the  practical  certainty 
that  the  boom  will  decline  more  or  less  suddenly  and  will 
leave  overvalued  stock  on  hand."  Companies  that  have  new 
plants  and  are  enjoying  prosperity  are  the  very  ones  which 
should  be  setting  aside  liberal  reserves  for  depreciation. 

It  is  not  intended  in  this  last  sentence,  however,  to  sug- 
gest that  the  practice  of  writing  off  depreciation  reserve  irregu- 
larly by  arbitrarily  setting  aside  such  sums  as  can  conveniently 
be  spared  out  of  the  annual  surplus,  is  one  to  be  encouraged. 
This  practice  is  followed,  it  is  true,  by  some  of  our  greatest 
and  best-managed  concerns,  notably  by  the  United  States 
Steel  Corporation.  But  it  is  essentially  unsound.  Deprecia- 
tion is  not  a  theory  or  a  vague  notion  in  some  one's  head ;  it 
is  an  actual  element  in  the  operation  of  every  business;  it  is 
going  on  night  and  day ;  through  all  seasons ;  year  after  year ; 
in  periods  of  depression  as  well  as  in  periods  of  prosperity. 
The  losses  due  to  depreciation  should  constitute,  therefore,  a 
regular  charge  against  gross  income.  The  amount  of  that 
charge  should  be  estimated  as  accurately  as  possible  and  should 
be  adhered  to  year  after  year;  otherwise  we  get  a  purely 
fictitious  showing  of  net  profits.  If  large  sums  are  charged 
off  in  one  year  and  nothing  is  charged  off  the  next  year,  the 
final  showing  of  profits  in  the  two  years  may  be  about  uni- 
form, whereas  the  business  has  perhaps  really  suffered  an 
enormous  fluctuation.     The  purpose  of  accounting  should  be, 


426  INTERNAL  FINANCIAL  MANAGEMENT 

not  to  conceal  such  facts,  but  faithfully  and  clearly  to  set  them 
forth. 

Depreciation  of  intangible  assets,  as  well  as  depreciation 
of  plant,  road-bed,  equipment,  and  the  like,  should  be  liberally 
estimated  and  provided  for.  In  fact,  it  is  generally  agreed 
that  the  practice  should  be  to  "write  oft"  intangible  assets 
at  an  especially  rapid  rate,  even  though  their  real  value  may 
not  be  decreasing.  Many  bankers  and  other  financial  men 
have  a  very  high  regard  for  what  is  called  a  "clean"  balance 
sheet,  that  is  to  say,  one  which  includes  only  tangible  assets 
at  their  cost  value  with  ample  depreciation  reserves.  This 
preference  seems  to  be  in  many  cases  little  more  than  a  preju- 
dice, inasmuch  as  such  assets  as  patents,  copyrights,  good- 
will, and  the  like  may  be  permanent  and  productive,  and 
may  properly  be  carried  as  real  assets.  Nevertheless,  even 
where  this  is  the  case,  it  is  often  advisable  to  cater  to  the 
prejudice  that  has  been  created  through  the  unscrupulous  and 
reckless  valuation  sometimes  placed  on  intangible  assets,  and 
to  carry  out  the  policy  of  "writing  off"  with  considerable 
rigor.  One  company  which  follows  this  practice  is  the  East- 
man Kodak  Company,  which  carries  depreciation  reserves 
of  over  25%  against  its  book  valuation  of  "properties,  patents, 
good- will,  etc." 

There  are  many  other  kinds  of  reserves  which  should  be 
carried  if  the  business  of  a  company  is  to  be  based  on  sound 
accounting  and  finance.  The  business  of  many  companies, 
for  example,  requires  them  to  enter  into  contracts  which  in- 
volve immediate  payment  on  the  part  of  the  purchaser  of  their 
products,  combined  with  a  liability  assumed  by  the  company 
to  render  future  service.  A  company  publishing  a  magazine 
usually  collects  subscription  payments  in  advance  and  con- 
tracts to  deliver  the  magazine  over  a  twelve  months'  period. 
This  being  the  case,  it  is  clear  that  the  company  actually  earns 
the  subscription  payment  only  as  it  proceeds  through  the 


DETERMINATION   OF  NET   INCOME  427 

year  with  the  delivery  of  its  magazine,  and  that  it  would  be 
improper  to  credit  the  subscription  payment  as  income  of  the 
week  or  month  in  which  it  is  received.  The  modern  custom 
among  magazine  publishers  is  to  credit  an  account  usually 
called  "Unearned  Subscriptions"  for  payments  sent  in  by  sub- 
scribers, and  at  the  close  of  each  month  to  debit  this  account 
and  credit  another  account  called  "Subscription  Earnings" 
for  the  proportion  actually  earned  by  sending  out  magazines 
during  that  month. 

Various  asphalt  paving  companies  include  in  their  paving 
contracts  guarantees  to  keep  the  streets  which  they  pave  in 
repair  for  a  certain  number  of  years.  At  first  the  guarantee' 
was  usually  5  years,  which  in  New  York  was  extended  to 
15  years,  and  in  some  other  cities  to  10  years;  later  the  guar- 
antee period  was  gradually  reduced  to  from  2  to  5  years. 
At  the  time  when  the  guarantee  system  was  first  introduced, 
insufficient  reserves  to  cover  expenditures  under  these  guaran- 
tees were  set  aside,  and  consequently  profits  at  this  stage  were 
greatly  overestimated.  During  1899  the  accounting  methods 
of  the  Barber  Asphalt  Paving  Company  showed  a  nominal 
profit  of  $474,000.  Later,  the  Audit  Company  of  New  York 
estimated  the  actual  profits  to  have  been  $35,700.  Most  of 
the  discrepancy  between  the  two  figures  was  due  to  the  fact 
that  the  company  originally  failed  to  set  aside  sufficient 
reserves  to  enable  it  to  meet  its  guarantees. 

Future  outgo  on  contracts  that  are  taken  Into  current  in- 
come account  should  be  watched  and  provided  for  with  the 
greatest  care.  Companies  that  are  conservatively  managed 
will  look  out  for  future  or  contingent  expenses  of  this  kind. 
In  a  recent  balance  sheet  of  Babcock  and  Wilcox,  for  example, 
one  item  consists  of  "Reserves  for  further  estimated  expendi- 
ture on  orders  invoiced."  An  account  under  some  such  title 
should  be  included  on  many  other  balance  sheets  where  it  is 
now  missing. 


428  INTERNAL   FINANCIAL  MANAGEMENT 

Operating  Expenses  and  Betterments 

We  have  spoken  above  of  charges  for  repairs,  renewals, 
maintenance,  and  depreciation  as  being  properly  included  in 
operating  expenses  or  in  deductions  from  gross  income,  and 
have  emphasized  the  necessity  for  liberal  allowances.  There 
is,  however,  a  possible,  although  not  so  frequent,  danger  of 
going  to  the  opposite  extreme.  Depreciation  charges  may 
be  too  high,  and  thus  the  showing  of  earnings  may  be  unduly 
depressed.  Boards  of  directors  sometimes  find  it  to  their 
advantage  to  see  that  reports  of  low  earnings  are  given  out 
to  stockholders  and  to  the  public  over  a  given  period,  so 
that  they  may  take  advantage  of  this  misinformation  to  buy 
up  the  company's  shares  at  bargain  prices. 

Again  the  various  accounts  included  under  the  general 
headings  of  "Repairs,"  "Renewals,"  and  "Maintenance"  may 
be  stretched  so  as  to  include  outlays  for  betterments.  In 
this  case  earnings  are  apparently  depressed  and  the  capital 
accounts  remain  stationary  although  the  capital  assets  are  at 
the  same  time  being  built  up.  Something  of  this  kind  has 
happened  most  frequently  in  the  management  of  railroad 
companies  in  the  United  States.  Conservatively  managed 
companies  have  frequently  included  in  their  "Maintenance" 
accounts,  expenditures  for  reballasting,  for  laying  heavier 
rails,  for  putting  in  permanent  culverts  and  even  bridges 
and  for  purchasing  new  locomotives  and  cars.  After  this 
practice  has  been  carried  on  over  a  period  of  years  and  the 
property  has  been  put  into  excellent  condition,  the  statements 
of  earnings  are  allowed  to  expand  to  their  correct  proportion 
and  the  stockholders  of  the  second  period  are  perhaps  given 
enlarged  dividends  or  a  "melon"  of  some  kind. 

A  notable  instance  is  the  Lehigh  Valley  Railroad  Company 
under  the  management  of  President  Walter  from  1898  to 
1904.  During  these  six  years  the  stockholders  noted  In  each 
year's  accounts  that  the  charges  for  maintenance,  repairs,  etc., 


DETERMINATION    OF    NET    INCOME  429 

were  growing  to  unprecedented  heights  and  that  the  net  profits 
were  correspondingly  reduced.  They  suspected  the  truth — 
that  expenditures  for  betterments  were  being  charged  into 
maintenance  accounts — and  many  of  them  protested,  but  with- 
out effect.  After  the  close  of  the  Walter  regime,  the  prop- 
erty was  found  to  be  in  remarkably  good  condition  and  the 
subsequent  financial  history  of  the  Lehigh  Valley  has  been 
one  of  progress  and  good  earnings. 

Is  Concealment  of  Betterment  Expenditures  Advisable? 

The  management  in  the  Lehigh  Valley  case,  and  in  many 
other  similar  cases,  took  the  attitude  that  they  were  the  ones 
best  acquainted  with  the  needs  of  the  corporation  and  were 
better  entitled  than  were  the  stockholders  to  judge  as  to 
the  necessity  for  betterment  expenditures.  They  believed, 
further,  that  stockholders,  if  the  decision  were  left  to  them, 
would  not  have  sufficient  patience  or  be  sufficiently  interested 
in  the  development  of  the  corporation  to  be  willing  to  have 
large  sums  set  aside  out  of  each  year's  earnings  in  order  to 
build  up  the  capital  assets.  It  might  have  been  possible,  to  be 
sure,  to  finance  the  required  betterments  by  fresh  issues  of 
obligations  and  of  stock,  but  the  management  believed  that  in 
view  of  the  past  financial  record  of  the  company,  this  could  not 
be  economically  accomplished.  They  took,  therefore,  the 
course  which  seemed  to  them  proper,  of  concealing — or  par- 
tially concealing — the  expenditures  for  betterments,  and  thus 
improved  the  property  of  the  corporation  without  the  knowl- 
edge or  consent   of  the   stockholders. 

The  motives  of  the  management  in  this  case  were  unim- 
peachable, and  there  can  be  no  doubt,  as  we  look  back,  but 
that  the  Lehigh  Valley  and  its  stockholders  as  a  body  have 
been  greatly  benefited  by  the  policy  that  was  followed.  And  yet 
this  conclusion  may  not  dispose  of  the  whole  question. 

The  stockholders  of  most  large  corporations  at  the  pres- 


430  INTERNAL    FINANCIAL    MANAGEMENT 

ent  time  can  scarcely  be  regarded  as  a  permanent  body  of 
individuals.  Shares  are  constantly  being  shifted  back  and 
forth  in  the  stock  market;  many  shareholders  do  not  regard 
their!  holdings  as  permanent  assets,  but  rather  as  temporary 
investments  which  they  intend  to  sell  whenever  they  may  need 
money.  Naturally,  each  set  of  stockholders  desires  to  secure 
as  large  returns  as  possible,  and  emphatically  does  not  desire 
to  have  earnings  secretly '  withheld  in  order  that  future  stock- 
holders may  reap  the  benefit.  Their  first  interest,  usually, 
is  not  in  the  corporation,  but  in  themselves.  And  we  must 
face  the  situation  that  actually  exists  in  many  large  corpora- 
tions in  which  the  interests  of  the  stockholders  and  the  inter- 
ests of  the  corporation  are  not  quite  identical.  Under  these 
conditions,  which  set  of  interests  shall  the  directors  elect 
to  serve?  Withers  quotes,  with  full  approval,  the  opinion 
which  is  forcibly,  though  dogmatically,  expressed  by  Pixley, 
as  follows:* 

It  is  not  incumbent  upon  the  directors  to  consider  in 
any  way  individual  shareholders,  or  a  special  group  of 
shareholders,  and  certainly  not  those  who  make  a  practice 
of  buying  and  selling  shares  and  holding  them  for  short 
periods.  It  is  their  duty  to  keep  the  capital  of  their  com- 
pany intact,  and  to  do  their  best  to  make  it  a  permanent 
institution. 

Equally  forceful  and  dogmatic  opinions  are  often  expressed 
by  shareholders  on  the  other  side. 

Perhaps  the  most  practical  conclusion  that  can  be  reached 
is  that  the  directors  should  consult  both  sets  of  interests  and, 
when  necessary,  should  compromise.  Certainly  they  should 
protect  and  keep  intact  the  property  of  the  corporation.  But 
in  so  doing  they  should  endeavor  to  avoid  injurious  conceal- 
ment of  facts  or  injustice  to  one  set  of  shareholders  as  com- 

*PixIey's  "Auditors:  Their  Duties  and  Responsibilities,"  quoted  in  Hartley  Withers* 
"Stocks  and  Shares,"  p.   156. 


DETERMINATION   OF  NET   INCOME  431 

pared  with  the  succeeding  set.  In  case  the  corporation  openly 
withholds  dividends  and  piles  up  a  surplus,  shareholders  know 
what  is  being  done  and  the  market  prices  of  their  holdings 
respond  to  the  true  status  of  the  company's  assets.  This 
was  demonstrated  over  a  period  of  several  years  by  the  Read- 
ing Railroad  Company,  the  shares  of  which  were  paying  4%, 
yet  for  years  were  sold  at  between  120  and  150.  The  ques- 
tion is  not  whether  the  accumulation  of  a  surplus  out  of  earn- 
ings is  advisable,  but  whether  concealment  of  the  accumulat- 
ing surplus  is  advisable.  Without  failing  to  recognize  the 
force  of  the  argument  that  can  be  advanced  in  favor  of  con- 
cealment, it  would  seem  that  the  reply  to  this  last  question 
should,  on  the  whole,  be  negative. 

In  those  not  infrequent  cases  where  directors  are  with 
reason  suspected  of  deliberately  withholding  and  concealing 
earnings  and  piling  up  a  secret  surplus  in  order  that  they  may, 
as  individuals,  profit  at  the  expense  of  their  fellow  share- 
holders, there  is,  of  course,  no  room  for  differences  of  opinion. 
This  last  case  is  simply  one  of  exploitation. 

Two  Classes  of  Betterments 

Before  leaving  this  subject,  it  may  be  well  to  call  attention 
to  the  two  different  classes  of  betterment  expenses  which  are 
generally  regarded  as  being  properly  financed  in  two  different 
ways.  One  class  consists  of  betterments  which  are  certain 
to  yield  a  definite,  traceable  return,  either  in  the  form  of 
enlarged  revenue  or  in  the  form  of  savings  in  outgo.  When 
a  railroad  company,  for  example,  decides  to  construct  a  tunnel 
and  straighten  out  its  line  between  two  given  points,  it  should 
be  readily  possible  to  calculate  not  only  the  cost  of  the  better- 
ment, but  also  almost  the  exact  amount  of  savings  that  it  will 
effect  in  fuel,  labor  and  the  like.  When  a  manufacturer  puts 
in  a  new  piece  of  machinery  in  order  to  turn  out  a  better  grade 
product,  he  should  usually  be  able  to  calculate  how  large  will 


432 


INTERNAL   FINANCIAL   MANAGEMENT 


be  the  increase  in  the  price  and  total  sales  of  the  new 
product. 

The  second  class  of  betterments  consists  of  those  which  are 
considered  desirable  and  well  worth  the  expense  involved,  but 
which  will  not  yield  direct  and  traceable  profits.  A  depart- 
ment store,  we  will  say,  decides  as  a  matter  of  business  policy 
that  it  should  build  and  furnish  a  handsome  recreation  and 
lunch  room  for  its  employees.  The  officers  are  satisfied  that 
the  result  will  be  to  increase  loyalty,  interest,  and  efficiency, 
and  thus  indirectly  build  up  the  store's  prestige  and  increase 
its  sales.  Nevertheless,  it  will  be  impossible  to  arrive  at  a 
mathematical  calculation  of  these  results.  The  directors  of  a 
bank  decide  that  they  will  put  up  a  fine  new  building  which 
will  constitute  the  best  kind  of  a  standing  advertisement  of 
the  bank's  stability.  Much  of  the  cost  of  the  building,  how- 
ever, will  not  be  represented  by  any  adequate  return  on  the 
invested  capital,  and  must  be  regarded,  therefore,  as  a  better- 
ment which  does  not  yield  traceable  results. 

By  general  consent  among  the  officers  and  directors  of 
great  corporations,  it  is  agreed  that  the  first  class  of  better- 
ments may  properly  be  financed  by  the  issuance  of  fresh  securi- 
ties, if  it  can  readily  be  shown  that  the  interest  or  dividends 
on  these  securities  will  be  provided  out  of  the  enlarged  income 
or  the  savings  made  possible  by  the  betterment.  The  second 
class  of  betterments,  however,  should  be  provided  for  out  of 
surplus.  They  may  prove  to  be  highly  profitable,  but  there 
is  no  certainty  on  that  point.  The  only  money  that  should 
be  spent  on  them,  therefore,  should  be  money  that  has  been 
accumulated  out  of  the  profits  of  the  preceding  years  or  that 
is  currently  accumulating.  In  case  the  judgment  of  the  di- 
rectors should  be  wrong,  and  the  betterments  should  not 
make  for  enlarged  profits,  the  corporation  would  at  least 
escape  a  loss  that  would  be  damaging  to  its  credit. 

The  Pennsylvania  Railroad  Company  has,  perhaps,  been 


DETERMINATION    OF   NET    INCOME 


433 


the  most  consistent  follower  of  the  principle  that  has  just 
been  presented.  In  financing  $150,000,000  of  improvements 
of  the  company  in  New  York  City  terminals,  including  tunnels 
under  the  North  and  East  rivers  and  the  magnificent  terminal 
building,  approximately  one-half  the  investment  was  provided 
by  fresh  issues  of  securities;  the  other  half  was  provided  by 
charges  against  the  surplus  of  the  Pennsylvania  Railroad  and 
allied  companies. 

Another  clear-cut  example  is  furnished  in  the  announce- 
ment of  the  London  and  South  American  Railroad  Company, 
which  in  October,  19 14,  brought  out  an  issue  of  £1,000,000 
5%  redeemable  preference  stock.  According  to  the  London 
Statist,  it  was  announced  that  the  proceeds  were  to  be  used 
for  electrifying  certain  sections  of  the  suburban  systems  of 
the  company: 

The  decision  was  come  to  that  it  would  not  be  right 
for  the  whole  cost  of  the  work  to  be  charged  against 
capital;  it  was  realized  that  to  some  extent  the  adoption 
of  electric  traction  is  in  reality  an  alteration  in  the 
method  of  working ;  the  one  kind  of  traction  merely  being 
substituted  by  another:  Therefore,  it  was  decided  that 
only  the  cost  of  the  power-house,  substations,  and  the 
third  rail,  should  be  charged  against  capital  account,  and 
that  other  items,  such  as  alteration  of  the  rolling  stock 
and  structures,  the  bonding  of  rails,  and  the  various  other 
expenses,  should  not  be  a  permanent  charge  upon  the 
revenue  of  the  company. 

Too  many  companies  rush  ahead  blindly  in  making  what- 
ever betterments  appeal  strongly  to  the  operating  ofificials, 
without  giving  sufficient  thought  to  the  soundness  of  their 
methods  of  financing  the  betterments.  One  of  two  results 
is  almost  certain  to  follow;  either  the  company  provides  the 
fresh  capital  required  too  largely  by  the  issuance  of  securities 
which  may  in  time  become  a  dangerous  burden;  or  the  ex- 


434  INTERNAL   FINANCIAL   MANAGEMENT 

penditures  for  the  betterments  are  unjustly  saddled  upon  the 
shoulders  of  those  who  happen  to  be  shareholders  at  the  time 
and  who  are  deprived  of  a  portion  of  the  earnings  to  which 
they  feel  rightfully  entitled.  In  this  latter  case,  the  policy 
may  be  followed  either  openly,  by  making  direct  charges 
against  surplus,  or  secretly,  by  including  expenditures  that 
are  really  for  betterments  under  operating  expenses. 

All  these  courses  of  action  are  objectionable.  The  real 
solution  is  to  be  found  in  the  careful  division  of  the  better- 
ments into  the  two  classes  that  have  been  named  and  in  the 
selection  of  corresponding  methods  of  financing.  In  this  case 
it  will  probably  be  comparatively  easy  to  convince  shareholders 
that  they  should  be  willing  to  sanction  reasonable  charges 
against  surplus  to  pay  for  betterments  of  the  second  class,  and 
it  will  not  be  be  necessary  to  conceal  these  betterments  in  any 
form.  In  that  case,  assuming  also  that  the  gross  earnings  of 
the  company  are  carefully  and  honestly  stated,  and  that  operat- 
ing expenses  include  all  the  charges  for  depreciation  and  other 
reserves  that  should  be  made,  the  result  will  be  to  arrive  at 
an  accurate  and  just  determination  of  net  income. 


CHAPTER    XIX 

DIVIDENDS 

Net  Income  and  Dividends 

After  the  amount  of  a  corporation's  net  income  has  been 
determined,  it  is  in  order  for  the  directors  to  consider  how  it 
shall  be^  distributed.  As  was  indicated  in  the  preceding  chapter, 
net  income  is  distributed  normally  through  three  channels, 
which  are  respectively  labelled :  fixed  charges,  dividends,  and 
additions  to  surplus. 

As  to  "Fixed  Charges''  there  is  little  that  needs  to  be 
said  at  this  point.  They  consist  of  taxes,  payments  on  leases 
and  rentals,  and  interest  payments  on  the  funded  obligations. 
The  amount  of  fixed  charges  (except  for  taxes)  is  determined 
by  the  amount  and  form  of  the  company's  capitalization  and 
of  its  long-term  contracts.  We  have  already  given  considera- 
tion to  the  problems  involved  in  drawing  up  a  financial  plan 
and  in  deciding  what,  if  any,  bond  and  note  issues  shall  be  put 
out.  At  the  time  when  net  income  for  a  given  period  has  been 
determined  and  its  distribution  is  under  advisement,  the  pay- 
ments for  fixed  charges  are  no  longer  questions  within  the 
discretion  of  the  directors  or  of  any  one  else  connected  with 
the  company.  Unless  they  are  paid  as  they  become  due,  the 
company  will  at  once  cease  to  be  solvent.  We  will  assume, 
therefore,  that  net  income  is  more  than  sufficient  to  meet  fixed 
charges,  and  that  there  is  remaining  a  balance  available  for 
dividends  and  surplus. 

As  to  the  distribution  of  this  balance  between  dividends 
and  surplus,  the  board  of  directors  is  the  sole  authority. 
Neither  officers  nor  stockholders,  as  such,  have  any  voice 

•     435 


436  INTERNAL   FINANCIAL   MANAGEMENT 

in  the  matter  and  there  are  few  effective  legal  restrktions. 
We  have  before  us,  then,  for  treatment  in  this  and  in  the 
following  chapter,  the  two  closely  related  questions : 

What  principles  should  guide  the  directors  in  fixing 
dividends  ? 

What  principles  should  guide  the  directors  in  accumulat- 
ing and  in  using  surplus? 

Two  classes  of  dividends  are  to  be  considered :  those  which 
are  preferred  and  cumulative  (with  which  may  be  included 
so-called  interest  on  income  bonds),  and  those  which  are 
common  or  ordinary  and  have  no  special  priorities. 

As  to  preferred  dividends,  much  the  same  reasoning  ap- 
plies as  has  just  been  stated  with  regard  to  fixed  charges. 
There  is  left,  to  be  sure,  a  much  larger  measure  of  discretion 
to  the  directors,  who  may,  at  their  option,  decide  to  defer  the 
payment.  But  there  is  a  corresponding  penalty  in  the  fact 
that  the  accumulated  dividends  constitute  a  growing  barrier 
in  the  way  of  common  dividends,  and  that  the  credit  of  a 
corporation  is  adversely  affected  by  piling  up  large  arrears 
of  preferred  dividends.  For  these  reasons  corporations  that 
are  earning  sufficient  profits  and  are  in  sufficiently  strong  finan- 
cial condition,  usually  pay  their  preferred  dividends  without 
much  argument.  There  are,  to  be  sure,  some  exceptions  to 
this  general  statement,  but  the  pressure  in  favor  of  payment 
of  preferred  dividends,  wherever  possible,  is  effective  in  the 
great  majority  of  cases. 

Preferred  dividends  which  are  not  cumulative  belong  in  a 
different  class.  The  interests  of  the  common  stockholders, 
whom  the  directors  usually  represent,  require  that  non-cumula- 
tive preferred  dividends  should  not  be  paid  until  common  divi- 
dends can  also  be  paid.  Hence  we  may  include  all  dividend 
charges  which  have  priority,  but  are  not  cumulative,  imder 
our  consideration  of  common  or  ordinary  dividends. 


DIVIDENDS  437 

Average  Rates  of  Dividends 

A  valuable  compilation  showing  the  amount  of  railway 
stock  in  the  United  States  which  pays  dividends,  the  percentage 
of  this  dividend-paying  stock  to  all  outstanding  stock,  and  the 
average  rates  of  dividends  over  a  period  of  years,  is  reprinted 
below  :* 

1900  $2,668,969,895  45.66  5.23  2.39 

1901  2,977,575,179  51.27  5.26  2.70 

1902  3,337,644,681  55.40  5.55  3.08 

1903  3450737.869  56.06  5.70  3.20 

1904  3,643,427,319  57.47  6.09  3.50 

1905  4,119,086,714  62.84  5.78  3.63 

1906  4,526,958,760  66.54  6.03  4.01 

1907  4,948,756,203  67.27  6.23  4.19 

1908  4,843,370,740  65.69  8.07  5.30 

1909  4,920,174,118  64.01  6.53  4.18 

1910  5,412,578,457  66.71  7.50  5.00 

191 1  5730,250,326  67.65  8.03  5.43 

1912  5,581,289,249  64.73  7-^7  4.64 

It  is  of  especial  interest  to  note  that  from  one-half  to  two- 
thirds  of  the  corporate  stock  outstanding  in  the  United  States 
during  recent  years  has  been  paying  dividends.  It  is  to  be  pre- 
sumed that  the  other  one-half  to  one-third  consists  almost 
wholly  of  common  stock  which  has  a  relatively  small  market 
value.  Doubtless  this  non-dividend  paying  stock  is  made  up 
only  in  part  of  securities  on  which  the  earnings  are  small.  It 
must  include  a  large  proportion  of  the  stock  of  new  or  growing 
corporations  which  are  deliberately  reserving  their  earnings 
for  the  purpose  of  building  up  the  business.  It  is  gratifying 
to  observe  the  rapid  increase  during  the  years  1900  to  1908 
in  the  percentage  of  dividend-paying  stock  and  in  the  average 
rates  of  return.     From  1908  to  1912,  the  earnings  in  propor- 


*  Bulletin  66  of  the  Bureau  of  Railway  Economics,  Washington,  1914. 


438 


INTERNAL   FINANCIAL  MANAGEMENT 


tion  to  outstanding-  stock  were  not  far  from  stationary.  In 
judging  these  figures,  it  may,  however,  be  assumed  that  a 
part  of  the  rapid  increase  in  stock  from  1900  to  19 12  was  due 
to  stock  dividends  or  other  methods  of  ''watering,"  so  that  the 
actual  increase  in  earnings  in  proportion  to  the  actual  invest- 
ment of  capital  has  probably  been  greater  than  the  tabulation 
would  indicate. 

In  most  other  countries  the  showing  could  not  be  nearly 
so  favorable.  It  is  clear  that  under  the  best  conditions  capital 
which  is  invested  in  stock  takes  a  considerable  risk  of  going 
without  dividend  returns. 

Percentages  of  Earnings  Devoted  to  Dividends 

An  instructive  tabulation  of  the  income  statements  of  about 
900  English  companies  for  the  year  ended  July  31,   19 14, 
shows  the  following  distribution  of  profits: 
» 

Net  Preferred  Ordinary  Surplus, 

Profits         Dividend  Dividend       Reserves,  etc. 

£  £%£%£% 

Breweries    2,409,759  486,255  20.2  1,312,820  54.4  610,684    25.4 

Gas    856,541  139,729  16.3  887,953  103.7  *i7i,i4i  *I9.8 

Iron,  Coal  &  Steel.  1,533,761  275,244  17.9  669,196  43-5  589,321     38.5 

Shipping    770,861  104,895  13.6  326,952  42.2  339,014    44-2 

Teas,  Rubber,  etc.    535,699  31,247  5-7  400,384  75.0  104,068    19.3 

Trusts  160,725  25,663  16.0  109,220  67.9  25,842    16.1 

Waterworks    ^2,^27  9,357  14.9  45,315  72-3  8,055     12.8 

Miscellaneous  ....3,160,147  945,715  29.9  i,473,99i  46.5  740,44i    23.6 

9,490,220  2,018,105    21.3    5,225,831     55.2   2,246,284    23.5 

•Deficit. 

It  appears  from  the  above  table  that  preferred  dividends 
received  21.3  of  the  net  profits  of  these  900  companies;  or- 
dinary dividends  received  55.2;  and  the  balance  added  to 
surplus  was  23.5. 

It  should  be  noted  in  passing  that  the  gas  companies  paid 


DIVIDENDS  439 

out  in  ordinary  and  preferred  dividends,  considerably  more 
than  their  net  profits,  showing  that  they  drew  in  this  year  upon 
the  surplus  accumulated  in  previous  years. 

The  London  Economist  comments  on  the  above  table  as 
follows : 

As  usual  the  iron  and  steel  and  shipping  companies 
have  adopted  a  conservative  policy  with  regard  to  the  dis- 
tribution of  profits  to  their  shareholders.  Most  of  the 
rubber  companies  have  no  preference  shares,  and  prefer 
to  maintain  their  high  dividends  at  the  expense  of  the 
reserve  funds.  A  very  high  percentage  of  the  profits  of 
the  water  and  gas  companies  goes  to  the  ordinary  share- 
holders, and  in  the  case  of  the  latter  large  reductions 
have  been  made  in  the  amounts  carried  forward  for  this 
purpose. 

Although  similar  compilations  for  companies  in  the  United 
States  are  not  available,  it  is  probable  that  the  results , would 
be  to  show  a  much  smaller  proportion  of  earnings  paid  out 
in  common  dividends  and  a  larger  proportion  reserved  for 
additions  to  surplus.  The  tendency  in  European  countries 
is  much  more  strongly  in  favor  of  paying  out  the  greater  por- 
tion of  earnings  in  the  form  of  dividends  than  it  is  in  the 
United  States.  Doubtless  this  is  due  in  large  part  to  the 
comparative  instability  of  economic  conditions  in  a  rapidly 
growing  country.  It  is  due  also,  however,  to  the  fact  that 
different  and  in  some  respects  more  conservative  standards 
of  capitalization  and  of  distribution  of  income  have  become 
established.  This  is  a  topic  which  will  be  more  fully  treated 
in  the  chapter  following.  It  is  in  the  meantime  enough  to 
point  out  that  the  statistics  of  a  group  of  companies,  although 
interesting  and  of  some  value  as  furnishing  a  standard  of 
comparison,  are  not  likely  to  prove  of  much  assistance  to 
directors  in  solving  the  problem  for  their  own  company. 
There  are,  however,  principles  which  have  been  almost  un- 


440 


INTERNAL   FINANCIAL   MANAGEMENT 


consciously  worked  out  through  the  experience  of  thousands 
of  corporations,  and  which  are  now  accepted  as  sound  by  most 
conservative  business  men.  These  principles  furnish  the 
safest  and  most  satisfactory  guide. 

Regularity  of  Dividends  Desirable 

The  principle  of  greatest  practical  importance  is  that  reg- 
ularity in  the  dividend  rate  is  highly  desirable.  This  prin- 
ciple must  be  regarded  as  almost  a  discovery  of  the  last 
generation  or  two.  Formerly,  the  unquestioned  practice  was 
to  regard  shareholders  as  standing  in  substantially  the  same 
relation  as  partners.  They  were  supposed  to  be  familiar  with 
the  status  and  fluctuations  of  the  business  and  were  expected 
to  share  in  its  ups  and  downs.  If  the  enterprise  enjoyed 
an  exceptionally  good  year,  it  was  accepted  as  a  matter  of 
course  that  the  dividend  rate  would  be  correspondingly  in- 
creased. If  in  the  following  year  there  was  a  sharp  decline 
in  profits,  the  dividend  rate  should  be  correspondingly  cut. 
As  a  matter  of  fact,  this  is  today  the  practice  of  a  great 
number — perhaps  the  majority — of  corporations.  In  so  far 
as  it  is  followed  by  close  corporations,  all  the  stock  of  which 
is  held  by  men  who  are  themselves  active  in  the  business  and 
familiar  with  its  every  phase,  it  is  probably  unobjectionable. 
It  is  a  matter  of  personal  preference  in  many  cases,  and 
has  the  advantage  of  stimulating  the  interest  of  those  share- 
holders who  are  active  in  the  business  to  the  highest  degree. 

But  the  corporation  which  has  shareholders  who  are  not 
active  in  the  business  or  familiar  with  it  is  in  a  different  situ- 
ation. This  remark  applies  with  especial  force  to  the  great 
corporations  that  number  their  shareholders  in  the  thousands 
or  tens  of  thousands.  The  great  majority  of  the  shareholders 
of  such  corporations  have  only  the  barest  information  as  to  the 
manner  in  which  the  business  is  handled  and  as  to  the  results 
that  are  being  achieved,  and  are  not  suf^ciently  familiar  with 


DIVIDENDS  441 

the  business  or  sufficiently  interested  in  it  to  absorb  more 
detailed  information  if  it  were  given  to  them.  They  regard 
their  ownership  of  a  company's  stock  purely  as  an  investment 
of  capital  that  will  bring  them  an  income.  They  buy  a  railroad 
or  an  industrial  stock  with  much  the  same  purpose  as  they 
would  have  in  buying  a  real  estate  mortgage — the  only  purpose 
being  that  of  securing  a  dependable  income  with  a  chance  at 
profits.  The  object  that  is  actually  in  their  minds  in  making 
the  purchase  is  not  a  partnership  interest  in  a  going  enterprise, 
but  certain  pieces  of  paper  called  ''certificates  of  stock"  which 
at  regular  intervals  will  bring  them  dividend  checks. 

To  shareholders  of  this  type  regularity  in  their  dividend 
returns  is  of  the  highest  importance.  They  count  upon  these 
returns  as  a  fixed  portion  of  their  income — indeed,  in  thousands 
of  instances  the  living  expenses  of  dependents  are  provided  out 
of  these  dividends.  Approximately  half  the  stockholders  of 
the  New  Haven  Railroad  are  women.  The  effort  of  the 
directors  of  a  corporation  which  includes  a  large  proportion 
of  shareholders  of  this  type  should  clearly  be  to  meet  their 
needs  by  paying  a  permanent  rate  of  dividends  with  the  fewest 
possible  fluctuations.  This  rate  of  dividends  in  a  really  stable 
and  conservatively  managed  corporation  never  varies  except 
when  it  is  increased.  And  it  is  not  increased  until  after  the 
directors  have  assured  themselves  that  in  all  human  probability 
a  later  decrease  will  not  become  necessary.  If  there  are  un- 
usual, or  possibly  temporary,  profits  which  it  is  thought  wise 
to  distribute,  the  directors  of  such  corporations  will  ordinarily 
announce  an  "extra"  dividend  or  once  in  a  while  will  cut  a 
''melon"  in  the  form  of  a  stock  dividend  or  a  subscription 
privilege.  These  extras,  however,  are  to  be  regarded  only  as 
incidents  which  should  not  be  allowed  to  disturb  the  regular 
and  uninterrupted  flow  of  dividends. 

The  desirability  of  maintaining  regularity  of  dividend  rates 
rests  not  merely  upon  the  duty  of  the  corporation  to  its  share- 


442  INTERNAL  FINANCIAL   MANAGEMENT 

holders,  but  also  upon  a  substantial  gain  for  the  corporation 
itself.  By  reason  of  the  fact  that  shares  which  yield  regular 
dividends  are  in  demand  by  so  large  a  body  of  owners  of 
capital  who  are  not  engaged  in  active  business,  there  is  a  much 
Stronger  demand  for  these  shares  than  for  those  which  are 
paying  irregular  dividends.  Out  of  two  issues  of  common 
stock  otherwise  equivalent,  one  of  which  is  paying  a  permanent 
dividend  rate  year  after  year  and  the  other  of  which  is  paying 
dividends  irregularly  but  averaging  at  least  as  high  as  the 
regular  payer,  the  first-named  issue  will  always  sell  at  a  sub- 
stantially higher  price.  For  this  reason,  the  corporation  which 
has  succeeded  over  a  period  of  years  in  maintaining  a  record 
of  dividend  stability,  and  which  has  not  changed  and  is  not 
likely  to  change  its  dividend  except  to  raise  it  to  a  permanently 
higher  level,  enjoys  the  benefit  of  a  credit  and  of  a  demand 
for  its  securities  which  is  worth  a  large  amount  of  money. 

For  both  these  reasons,  even  the  smaller  corporations  are 
tending  more  and  more  strongly  toward  so  adjusting  their 
affairs  that  regularity — or  at  least  approximate  regularity — 
of  their  dividend  rates  can  be  attained.  It  is  coming  to  be 
more  and  more  widely  recognized  by  bankers,  investors,  and 
the  public  at  large,  that  the  ability  of  a  company  to  maintain 
regular  rates  is  a  better  test  of  its  soundness  than  is  its  ability 
to  pay  high  but  irregular  dividends. 

Variability  of  Profits 

In  sharp  contrast  to  the  desired  regularity  of  dividend 
payments  is  the  wide  fluctuation  in  profits  that  is  characteristic 
of  the  majority  of  corporations.  Business  does  not  move  on 
a  regular  and  even  keel.  Economic  and  financial  conditions 
vary ;  changes  in  management  occur ;  difficulties  with  employees 
arise;  changes  in  taste  may  suddenly  create  new  markets  or 
wipe  out  markets — all  these  and  many  other  factors  which  are 
constantly  at  work  bring  about  kaleidoscopic  changes  which 


DIVIDENDS  443 

often  come  as  great  surprises  even  to  people  who  are  intimately 
acquainted  with  the  business.  The  sudden  outbreak  of  the 
European  War  in  1914,  followed  by  an  intense  depreciation 
in  iron  and  steel  and  machinery  industries,  was  an  unexpected 
variation  of  this  kind.  Within  a  few  months  it  was  followed 
by  an  unprecedented  demand  from  the  European  nations  at 
war  for  the  products  of  American  farms  and  factories,  stimu- 
lating production  and  prices  to  an  unheard-of  extent ;  this  was 
a  variation  no  less  surprising.  It  is  not  necessary,  however, 
to  cite  the  extraordinary  conditions  produced  by  the  European 
War. 

Rapid  fluctuations  are  constantly  •  taking  place  even  under 
normal  conditions.  During  the  fiscal  year  1913,  the  Lacka- 
wanna Steel  Company  earned  over  $3,000,000  available  for 
dividends  on  its  common  stock,  equal  to  8.3 ;  in  the  fiscal  year 
1 9 14,  prior  to  the  outbreak  of  the  European  War,  the  same 
company  showed  a  deficit,  after  payment  of  fixed  charges, 
amounting  to  $1,500,000.  The  experience  of  the  Mount 
Vernon- Woodberry  Cotton  Duck  Company  after  its  formation 
is  typical  of  sudden  fluctuations  that  are  apt  to  occur  in  any 
industry.  At  the  time  the  combination  was  formed  in  1899 
there  was  a  large  demand  for  its  product.  In  the  first  six 
months  of  1900  net  manufacturing  profits  were  more  than 
$750,000;  in  the  second  six  months  of  the  same  year,  the 
profits  sank  to  $350,000;  in  the  first  six  months  of  1901  there 
was  a  manufacturing  deficit  of  $200,000,  to  which  should  be 
added  fixed  charges  of  $175,000.  Certain  lines  of  business, 
such  as  building  construction,  ship  construction,  iron  and  steel 
manufacturing,  and  manufacturing  of  novelties  and  articles 
of  fashion  or  luxury,  are  peculiarly  subject  to  great  fluctua- 
tions. In  Andrew  Carnegie's  famous  phrase  these  industries 
are  either  ''prince  or  pauper.'* 

On  the  other  hand,  industries  which  sell  small  articles  for 
personal  use,  such  as  cigars  or  household  sundries,  are  likely 


444 


INTERNAL   FINANCIAL   MANAGEMENT 


to  avoid  fluctuation.  The  business  of  the  large  five-and-ten- 
cent  stores  is  especially  stable ;  owing  to  the  fact  that  they  are 
operated  on  a  strictly  cash  basis,  there  is  usually  little  difficulty 
in  adjusting  expenditures  to  sales.  During  August  and  Sep- 
tember of  1914,  when  almost  all  other  lines  of  business  were 
suffering,  the  business  of  F.  W.  Woolworth  Company  and 
S.  S.  Kresge  Company  both  showed  very  satisfactory  increases 
over  the  business  of  preceding  years. 

Companies  which  follow  the  policy  of  protecting  their  cus- 
tomers and  of  charging  prices  that  yield  them  only  a  moderate 
rate  of  profit  are  likely  to  be  rewarded  by  being  able  to  main- 
tain a  fairly  steady  volume  of  sales  and  of  profits.  If  this 
policy  results  in  stabilizing  dividends,  the  credit  of  the  com- 
pany may  be  so  much  enhanced  as  to  be  of  much  greater  value 
than  any  excessive  profits  it  might  have  extracted  from  its 
customers. 

Although  companies  differ  widely  among  themselves,  they 
are  all  subject  to  a  greater  or  less  degree  of  fluctuation  in  their 
profits  and  at  the  same  time  (with  the  exception  of  the  closely 
held  corporations)  they  are  all  under  pressure  to  maintain 
regular  rates  of  dividends.  How  are  these  two  conditions 
to  be  reconciled  ? 

Rule  for  Maintaining  Regularity  of  Dividend  Rate 

There  is  obviously  only  one  satisfactory  answer — dividends 
must  not  be  allowed  to  rise,  even  in  the  most  prosperous 
periods,  above  a  conservative  estimate  of  the  minimum  earn- 
ings of  the  company.  Those  concerns  which  suffer  from 
great  fluctuations  find  this  to  be  a  harsh  rule.  It  means  that, 
so  long  as  there  remains  even  a  reasonable  possibility  that 
earnings  may  sink  close  to  or  below  the  level  of  fixed  and  con- 
tingent charges,  no  dividends  whatever  should  be  paid.  This 
has,  in  fact,  been  the  rule  followed  by  all  really  successful 
corporations  the  nature  of  the  business  of  which  involves  un- 


DIVIDENDS 


445 


avoidable  fluctuations.  The  Carnegie  Steel  Company  ran  as 
a  highly  successful  corporation  for  many  years  without  paying 
dividends.  When  Charles  M.  Schwab  took  control  of  the 
Bethlehem  Steel  Corporation  in  1902  and  started  to  build  it 
up,  it  was  on  the  basis  of  devoting  all  the  earnings  to  up- 
building without  paying  a  cent  of  dividends — and  the  policy  has 
since  been  rigorously  followed.  Even  after  a  corporation  of 
this  nature  begins  to  pay  dividends,  it  is  not  to  be  expected, 
if  the  management  is  conservative,  that  they  will  rise  any- 
where near  the  level  of  the  average  earnings.  The  rule  of 
keeping  dividend  payments  below  the  level  of  minimum  earn- 
ings must  strictly  be  adhered  to. 

Possibly  the  net  result  may,  at  first  glance,  seem  to  be  a 
permanent  loss  to  the  shareholder,  who  can  never  expect  on 
this  principle  to  receive  in  dividends  any  large  proportion  of 
the  actual  earnings  of  their  corporation.  However,  this  loss 
is  apparent,  not  real,  for  two  reasons : 

1.  The  proportion  of  earnings  paid  out  in  dividends  being 
small,  there  is  a  rapid  increase  in  the  productive  capacity  of  the 
company,  due  to  betterments  provided  out  of  surplus,  and  this 
increase  may  in  the  course  of  a  few  years  raise  even  the 
minimum  net  earnings  far  above  the  average  earnings  that 
would  otherwise  have  been  received. 

2.  The  very  fact  that  lines  of  business  in  which  great 
fluctuations  occur  call  for  extreme  patience  and  self-denial  on 
the  part  of  shareholders,  means  that  comparatively  few  men 
are  willing  to  put  their  capital  and  energy  into  getting  a  busi- 
ness of  this  nature  thoroughly  well  established  and  that  oppor- 
tunities for  exceptionally  large  profits  are,  for  this  reason, 
left  open. 

It  is  partly  owing  to  this  condition  that  Andrew  Carnegie 
and  his  partners  built  up  their  wonderfully  profitable  iron  and 
steel  business.  Their  earnings  year  after  year  went  back 
into  the  business,  and  they  did  not  themselves  realize  the  full 


446  INTERNAL   FINANCIAL  MANAGEMENT 

value  of  the  property  they  had  created.  But  when  the  time 
arrived  for  the  formation  of  the  United  States  Steel  Corpora- 
tion, the  market  value  of  the  securities  that  went  to  the 
Carnegie  Company  was  well  over  $500,000,000.  The  same 
rule  could  be  applied  with  even  less  question  and  more  rigor 
to  those  corporations  which  conduct  a  comparatively  stable 
business.  For  them  it  is  only  a  minor  hardship  to  keep  divi- 
dend payments  below  the  level  of  minimum  earnings.  This 
regularity  of  dividend  payments  results  in  a  gain  in  credit 
that  is  secured  with  relatively  little  sacrifice. 

Policies  of  Important  Companies 

Taking  a  few  examples  first  of  regularity  of  dividends,  we 
have  such  records  as  that  of  the  American  Express  Company, 
which  paid  regular  dividends  every  year  from  1882  to  1901 
of  6% ;  from  1901  to  1906  of  8% ;  from  1906  to  1912  of  12%. 
The  Mergenthaler  Linotype  Company,  during  the  ten  years 
1902  to  191 2,  paid  10%  regular  dividends  plus  a  5%  extra 
dividend  each  year,  making  15%  annually.  The  Perra  Salt 
Manufacturing  Company  has  paid  12%  annually  since  1863. 

The  dividend  record  of  the  John  B.  Stetson  Company, 
which  follows,  is  an  excellent  example  of  stability  combined 
with  liberal  distribution  of  large  profits  accumulated  during 
the  earlier  years  of  the  company's  existence.  It  will  be  noted 
that  after  1893  dividends  were  decreasing  slightly,  but  this  is 
to  be  explained  by  reason  of  the  great  depression  from  1893 
to  1896  which  could  not  reasonably  have  been  foreseen: 

John  B.  Stetson  Co.  (Hats) 
Common  Dividend  Record 

1892  6%  1896  4% 

1893  6%  1897  5% 

1894  4%  1898  8% 
iS^S  4%  1899  12% 


DIVIDENDS 

447 

1900 

15% 

1908 

25%  and  25%  extra 

I90I 

17% 

1909 

25% 

1902 

17% 

1910 

25%     "    25%     " 

1903 

20% 

1911 

25% 

1904 

20% 

1912 

25%     "    25%     « 

1905 

20% 

and 

5% 

extra 

1913 

25% 

1906 

20% 

<< 

5% 

(( 

1914 

25% 

1907 

20% 

(( 

5% 

(( 

1915 

25% 

The  Merchants  and  Miners  Transportation  Company  has 
been  paying  dividends  at  the  rate  of  20%  since  1856. 

The  dividend  record  on  the  common  stock  of  the  Proctor 
and  Gamble  Company,  manufacturers  of  soap,  has  been  as 
follows : 

1891  8% 

1892-1897  12%  per  annum 
1898-1900  20%  per  annum 
1901-1913     12%  per  annum 

1913-1915     16%  per  annum   plus    a  4%    common   stock 

dividend 

The  apparent  decrease  in  dividends,  beginning  in  1901, 
was  due  purely  to  the  fact  that  in  December,  1900,  the  out- 
standing issue  of  common  stock  was  doubled  by  a  100%  stock 
dividend.  In  reality,  therefore,  the  new  dividend  of  12% 
was  equivalent  to  a  dividend  of  24%  on  the  former  issue.  In 
addition  to  the  regular  dividend,  the  company  paid  an  extra 
dividend  of  14.2%  in  January,  1904,  and  another  extra  divi- 
dend of  25%  in  December,  1905. 

The  Eastman  Kodak  Company  has  paid  regular  10%  divi- 
dends since  1902,  but  with  extra  dividends  in  most  years, 
running  from  as  low  as  9j^%  to  as  high  as  30%.  These 
extra  dividends  are  so  high  that  they  overshadow  the  regular 
dividends,  and,  if  any  criticism  of  so  successful  an  enterprise 
is  permissible,  it  may  be  based  on  the  desirability  of  attaining 
a  greater  degree  of  regularity  in  the  extra  as  well  as  in  the 
so-called  "regular"  disbursements. 


448  INTERNAL   FINANCIAL   MANAGEMENT 

On  the  other  hand,  concerns  engaged  in  fluctuating  lines 
of  business,  frequently  decline  to  restrict  themselves  to  the 
payment  of  a  fixed  dividend  rate.  The  dividends  of  the  Amal- 
gamated Copper  Company  from  1899  to  191 2,  ranged  from 
lyifo  to  73^%,  and  of  the  Anaconda  Copper  Company  from 
as  low  as  3%  in  1913  to  26%  in  1907.  There  is  less  excuse 
in  the  case  of  the  American  Thread  Company,  the  business  of 
which  is  relatively  stable;  nevertheless  from  1902  to  19 12, 
dividends  varied  from  as  low  as  4%  to  as  high  as  16%.  The 
Bourne  Mills  between  1897  and  191 2  paid  dividends  which 
fluctuated  from  as  low  as  3%  to  as  high  as  49}^%. 

Following  is  the  record  of  the  Porto  Rican  American  To- 
bacco Company,  which  is  even  more  remarkable  for  the  extent 
and  rapidity  of  its  fluctuations : 


1904 

8    % 

1905 

3i>^% 

1906 

84    % 

1907 

10/2% 

1908 

5    % 

1909 

9    % 

I9I0 

14    % 

I9II 

16% 

I9I2 

16    %  plus  20%  (scrip) 

I9I3 

20     %   (scrip) 

I9I4 

20     %   (scrip) 

I9IS 

8     %  plus  5%  (scrip) 

The  Atlantic  Refining  Company,  like  various  companies 
of  the  oil  and  other  extractive  industries,  prefers  to  allow  its 
dividends  to  fluctuate  with  its  profits.  Before  the  disintegra- 
tion of  the  Standard  Oil  Company  it  was  customary  for  the 
directors  to  make  up  their  minds  at  the  end  of  each  quarter 
what  rate  of  dividend  for  the  quarter  should  be  declared.  In 
this  case  the  fact  that  the  company,  although  of  enormous  ex- 
tent, was  comparatively  closely  held,  was  no  doubt  another 
reason  for  following  the  practice. 


DIVIDENDS  449 

From  companies  engaged  in  extractive  industries  come  the 
most  remarkable  records  of  enormous  profits,  and  it  is  perhaps 
natural  that  the  desirability  of  stability  in  their  dividend 
disbursements  should  not  appeal  to  them  as  of  great  impor- 
tance. The  Calumet  &  Hecla  Mining  Company,  which  has 
outstanding  about  $2,500,000  of  capital  stock  with  a  par  value 
of  $25,  of  which  only  $12  per  share  is  paid  up,  has  paid  out 
total  dividends  from  1871  to  19 13  amounting  to  over  $121,- 
000,000.  One  of  the  largest  dividend-payers  was  the  Koloniale 
Bergbau  Gesellschaft  (Colonial  Mining  Company),  a  German 
concern,  which  operated  diamond  mines  in  German  Southwest 
Africa.  Its  capital  is  only  about  $25,000.  Its  dividend  record 
before  the  war  was : 

1910  2,400% 

1911   2,500% 

1912 3.800% 

1913  2,500% 

Total  for  four  years 1 1,200% 

That  many  manufacturing  companies  have  not  yet  reached 
the  ideal  condition  above  described  of  paying  regular  rates 
of  dividend  which  are  never  changed  except  to  be  increased, 
is  shown  by  the  record  for  the  18  months — ^January  i,  19 13 
to  July  I,  1914 — of  industrial  corporations  the  stock  of  which 
is  listed  on  American  stock  exchanges.  Forty-three  of  these 
companies  passed  their  dividends;  sixteen  others  reduced  tiieir 
dividends.  This  took  place  in  a  period  of  depression,  to  be 
sure,  but  not  in  a  period  of  sudden  or  overwhelming  crisis. 

The  great  advantage  of  prudent  management  in  the  main- 
tenance of  a  low  but  regular  rate  of  dividends  is  shown  in  the 
record  during  recent  years  of  two  great  railroad  companies. 
In  19 1 3  the  earnings  of  the  Pennsylvania  Railroad  Company 
fell  to  the  lowest  figures  except  one  in  fifteen  years,  and  in 
19 14  there  was  a  further  sharp  decline.    Nevertheless,  even  at 


450 


INTERNAL  FINANCIAL   MANAGEMENT 


this  level  the  company's  regular  6%  dividends  were  not  for 
a  moment  endangered.  In  19 14  and  191 5  the  Canadian  Paci- 
fic Railroad  Company  passed  through  a  tremendous  crisis 
brought  on  by  the  European  War.  It  had  been  the  practice 
of  this  company  to  pay  a  regular  dividend  of  7%  out  of  operat- 
ing earnings  and  an  additional  dividend  of  3%  derived  from 
the  company's  holdings  of  securities  in  subsidiary  enterprises. 
Although  during  the  year  of  crisis,  the  7%  was  not  fully 
earned,  income  from  other  sources  was  sufficient  to  enable  the 
company  to  go  ahead  with  its  regular  10%  rate. 

Paying  Dividends  from  Accumulated  Surplus 

Frequently  the  question  arises  whether  dividends  which 
have  not  been  earned  during  a  given  period  should  nevertheless 
be  paid  and  charged  against  the  surplus  that  has  been  acaimu- 
lated  in  previous  periods.  Ordinarily  the  answer  that  should 
immediately  be  given  is,  no.  In  ordinary  practice  surplus, 
as  will  be  more  clearly  emphasized  in  the  chapter  following, 
is  as  much  a  part  of  the  permanent  capital  of  a  company  as 
is  the  capital  stock  itself.  It  is  not  invested  in  such  a  form 
as  to  make  it  available  for  the  payment  of  dividends  and  it  is 
understood  as  a  matter  of  course  by  the  creditors  of  the  com* 
pany  that  it  represents  a  permanent  investment. 

All  this  refers  to  customary  financial  practice,  and  not  to 
the  legal  view  of  surplus  which  makes  no  distinction  between 
that  which  has  been  accumulated  in  the  past  and  that  which 
is  current.  The  legality  of  paying  dividends  out  of  accumu- 
lated surplus,  which  has  seldom  been  seriously  questioned,  was 
reaffirmed  in  the  New  York  courts  in  19 14  in  an  action  brought 
by  the  preferred  shareholders  of  the  Union  Pacific  Railroad 
Company  to  enjoin  the  distribution  of  certain  shares  of 
stock  and  amounts  of  cash  held  in  the  treasury  of  the  com- 
pany to  the  common  shareholders.  The  Union  Pacific,  which 
had  been  paying  10%  per  annum,  desired  to  distribute  securi- 


DIVIDENDS  451 

ties  and  cash  which  would  yield  2%,  and  thereupon  to  reduce 
its  regular  dividend  payment  to  8%.  Certain  preferred  share- 
holders objected  on  the  ground  that  this  extra  distribution 
would  be  charged,  not  against  current  surplus,  but  against 
accumulated  surplus,  and  that  the  preferred  shareholders  had 
acquired  a  vested  right,  as  a  part  of  their  equitable  interest  in 
the  company,  to  be  protected  by  the  full  amount  of  the  accumu- 
lated surplus.  No  legal  grounds  for  granting  the  injunction 
asked  for  were  found  by  the  court  and  the  action  was  dis- 
missed. Granting,  then,  that  accumulated  surplus  is  legally 
available  for  the  payment  of  dividends  and  that  customary 
practice  makes  it  unavailable,  the  question  still  remains  whether 
exceptions  to  this  customary  practice  should  ever  be  admitted. 
In  July,  1 9 14,  the  directors  of  the  Baltimore  and  Ohio  Rail- 
road Company  voted  the  usual  semiannual  dividend  of  2% 
on  the  preferred  and  3%  on  the  common.  The  required  total 
of  dividends  for  the  year,  which  amounted  to  $11,538,888, 
was  greater  than  the  surplus  during  the  year  by  $2,469,095. 
It  was  explained  unofficially  that  the  company  had  not  exer- 
cised its  privilege  of  prorating  depreciation  charges  over  a 
series  of  years,  but  had  charged  against  current  earnings  over 
$2,000,000  of  losses  incurred  in  the  Central  Western  floods 
of  March,  19 13.  The  action  of  the  directors  was  based  on 
the  belief  that  the  decline  in  earnings  was  only  temporary, 
and  on  a  profound  desire  to  maintain  an  unblemished  record 
of  regular  dividends.  There  is  no  question  as  to  the  conserva- 
tism and  ability  of  the  board  and  this  action  was  somewhat 
grudgingly  accepted  by  the  financial  community  as  sound  and 
correct.  Nevertheless,  it  is  by  no  means  to  be  regarded  as  a 
precedent,  but  only  as  an  isolated  concession. 

Cash  Requirements  for  Dividends 

In   discussing  the  payment  of  dividends  so  far  in  this 
chapter,  our  attention  has  been  concentrated,  as  is  usually  the 


452 


INTERNAL  FINANCIAL   MANAGEMENT 


case,  on  the  relation  between  dividends  and  profits.  It  has 
been  assumed  that  adequate  and  regular  profits — provided  they 
are  correctly  estimated — ^justify  dividends.  But  this  assump- 
tion must  not  be  permitted  to  stand  longer  unchallenged.  It 
is,  in  fact,  the  direct  source  of  a  large  proportion  of  financial 
embarrassments.  Thousands  of  corporations  which  have  been 
able  to  report  highly  satisfactory  profits  and  which  have  paid 
good  dividends  on  the  strength  of  those  profits,  have  found 
themselves  a  short  time  later — to  the  intense  surprise  and  in- 
dignation of  their  stockholders  and  even  of  their  directors 
and  officers — in  the  hands  of  their  creditors.  It  is  quite  ap- 
parent that  many  business  men,  even  including  some  of  unusual 
capabilities,  do  not  fully  grasp  the  fact  that  dividend  pay- 
ments should  be  dependent  not  only  upon  profits,  but  also  upon 
the  corporation's  cash  position. 

The  point  has  already  been  emphasized  and  will  later  be 
reiterated,  that  many  companies  find  their  chief  financial  diffi- 
culties arising  not  in  periods  of  depression  and  small  business, 
but  in  their  periods  of  prosperity.  To  attempt  to  do  a  large 
volume  of  business  with  a  small  working  capital  is  one  of  the 
quickest  and  surest  methods  of  financial  hari-kari.  Yet  this  is 
precisely  the  course  that  is  followed  by  those  concerns  which, 
on  the  strength  of  a  showing  of  profits,  declare  dividends,  the 
payment  of  which  seriously  depletes  their  working  capital. 
Under  these  conditions  the  only  prudent  course  is  to  withhold 
dividends  until  in  the  normal  course  of  the  company's  business 
cash  is  accumulated  beyond  the  requirements  of  the  business. 
It  is  not  merely  a  book  surplus,  but  in  addition  a  satisfactory 
cash  balance,  that  should  furnish  the  basis  for  a  declaration  of 
cash  dividends. 

To  give  a  concrete  illustration  of  a  situation  which  does 
not  justify  cash  dividends,  we  may  take  the  case  of  a  flour 
mill  company  operating  in  Canada  which  has  outstanding 
capital  stock  of  $1,000,000.     During  a  recent  year  the  com- 


DIVIDENDS 


453 


pany  reported  net  profits  available  for  dividends  amounting 
to  $91,462,  and  declared  dividends  of  $30,000,  or  3%,  leaving 
an  addition  to  the  surplus  of  $61,462.  On  the  face  of  it 
there  would  seem  to  be  no  reasonable  question  as  to  the  con- 
servatism of  this  sm.all  dividend  declaration.  When  we  come 
to  examine  the  company's  balance  sheet  after  payment  of  the 
dividend,  however,  we  find  that  it  shows  a  secured  overdraft 
at  its  bank  of  $191,000.  Its  cash  on  hand  is  less  than  $6,000, 
and  its  cash  and  receivables  together  are  less  than  its  current 
liabilities.  A  glance  at  this  balance  sheet  is  enough  to  prove 
that  the  payment  of  dividends  was  not  merely  unwise,  but  a- 
thoroughly  reckless  and  dangerous  proceeding. 

Another  example,  which  indicates  clearly  the  results  to 
stockholders  of  carelessness  in  figuring  on  cash  requirements 
for  dividends,  is  furnished  by  the  history  of  the  New  England 
Cotton  Yarn  Company  which  was  in  existence  from  1899  to 
1903.  During  these  four  years  the  company  was  earning  suffi- 
cient profits  out  of  which  to  pay  preferred  stock  dividends  and 
actually  paid  these  dividends,  amounting  in  the  aggregate  to 
$1,212,500.  During  the  four  years  cash  fell  approximately, 
from  $2,000,000  to  $500,000;  notes  payable  which  had  been 
at  one  time  reduced  to  as  low  as  $650,000,  rose  before  end  of 
the  four  years  to  over  $2,000,000.  The  inevitable  result  was 
receivership.  Without  the  heavy  outgo  of  cash  dividends 
this  might  have  been  avoided.  Even  the  preferred  stock- 
holders who  received  the  dividends  were  heavy  losers  by  this 
policy;  although  they  received  $24.25  a  share  in  dividends,  the 
market  value  of  their  stock  went  down  from  $105  to  $25.* 

Paying  Dividends  with  Borrowed  Cash 

Sometimes  circumstances  arise  which  justify  the  directors 
of  a  corporation,  in  their  opinion,  in  borrowing  the  money 
with  which  to  pay  dividends.    This  is,  in  fact,  quite  frequently 

*Dewing's  "Corporate  Promotions  and  Reorganizations,"  p.  324. 


454  INTERNAL   FINANCIAL   MANAGEMENT 

the  case  with  companies  which  have  to  contend  with  wide 
seasonal  fluctuations  and  with  companies  which  normally  oper- 
ate with  a  small  working  capital.  As  has  previously  been 
pointed  out,  transportation  and  communication  enterprises 
frequently  belong  in  this  last-named  group.  Commenting  on 
numerous  cuts  in  the  dividends  of  railway  corporations,  the 
London  Financial  Times  of  October  2,  1914,  says  editorially: 

It  is  necessary  to  be  guided  by  the  amount  of  cash 
actually  in  the  till.  Borrowing  on  temporary  loans  from 
one's  bankers  in  order  to  make  up  the  heavy  amount  of 
ready  cash  required  to  pay  dividends — a  common  and 
perfectly  proper  procedure  in  normal  times — is  much 
less  desirable  under  existing  financial  conditions. 

For  companies  of  the  two  types  just  referred  to,  it  may  be 
sound  policy  at  times  to  pay  dividends  with  the  proceeds  of 
temporary  bank  loans — assuming,  of  course,  that  there  can; 
be  no  reasonable  question  as  to  the  company's  ability  to  repay 
these  loans  without  crippling  itself.  There  is  a  great  distinc- 
tion, however,  between  this  situation  and  that  which  exists 
when  a  corporation  issues  long-term  obligations  or  when  it 
sells  additional  stock  in  order  to  obtain  money  with  which 
to  pay  dividends.  If  a  corporation  were  to  follow  this  prac- 
tice during  a  period  when  it  was  not  actually  making  a  legiti- 
mate showing  of  profits,  it  would  be  clearly  engaged  in  a. 
fraudulent  transaction.  When  it  issues  long-term  obligations 
or  sells  additional  stock  during  a  period  of  adequate  profits  or 
for  the  purpose  of  paying  dividends  that  are  charged  against 
accumulated  surplus,  its  course  of  action  is  not  necessarily 
fraudulent,  but  it  is  certainly  open  to  serious  question  as  to  itj 
essential  soundness. 

A  case  which  aroused  a  great  deal  of  discussion  in  financia 
circles  occurred  in  191 3,  when  the  management  of  the  Ameri- 
can Can  Company  decided  that  the  time  had  arrived  wher 
it  was  advisable  to  pay  up  a  portion  of  the  dividend  claims 


DIVIDENDS 


455 


on  its  preferred  stock  issue  which  had  been  accumulating  over 
a  period  of  several  years.  The  company  sold  an  issue  of 
$14,000,000  5%  debenture  bonds  and  with  the  cash  proceeds 
paid  a  24%  dividend  on  preferred  stock.  The  consensus  of 
opinion  among  conservative  judges,  it  may  safely  be  said,  was 
that  it  would  have  been  far  wiser  to  have  paid  off  the  arrears 
of  preferred  dividends  gradually  out  of  profits  as  they  accumu- 
lated. Although  it  is  true  that  this  plan  would  have  involved 
deferring  common  dividends  for  a  period  of  years,  it  would 
have  put  the  company  eventually  into  a  position  of  undoubted 
financial  strength. 

Effects  of  Lack  of  Prudence  in  Paying  Dividends 

It  seems  almost  superfluous,  after  what  has  been  said  above, 
to  cite  examples  of  financial  difficulties  which  are  traceable  to 
the  payment  of  dividends  which  were  not  earned  or  which 
could  not  be  met  without  reducing  working  capital  below  the 
limits  of  safety.  The  number  of  examples  is  practically  in- 
finite. Some  of  the  most  flagrant  are  furnished  by  the  records 
of  important  industrial  combinations.  Following  is  a  self-ex- 
planatory extract  from  a  review  published  in  the  London 
Statist  of  October  17,  1914: 

The  evil  result  of  continually  paying  out  the  earnings 
of  a  company — and  perhaps  a  little  more — may  be  illus- 
trated from  the  experience  of  Dick,  Kerr  and  Co.  The 
annual  net  trading  profits  of  this  company  for  a  series 
of  years  has  been  as  follows: 

1909   £28,168 

1910   22,821 

1911    37,994 

1912 3,27s 

1913   30,092 

1914   44762 

On  the  whole,  the  net  profits  show  a  favorable  ten- 
dency toward  increase,  although  this  is  strikingly  inter- 


456  INTERNAL    FINANCIAL   MANAGEMENT 

rupted  by  the  bad  year,  1912.  In  1909-10-11,  the  company 
paid  in  addition  to  its  full  debenture  interest,  preference 
dividends  amounting  to  £18,300  and  ordinary  dividends 
amounting  to  £13,000,  leaving  annual  deficits  as  follows: 

1909   ^18,425 

1910   20,884 

1911    5*366 

In  1912,  the  ordinary  dividends  v^ere  cut  off  and  have 
not  since  been  resumed,  but  the  preference  dividends 
were  continued  with  the  result  that  in  that  year  a  deficit 
was  still  shown  of  £26,876.  In  the  following  year  there 
was  a  surplus  of  £309,  and  in  1914,  a  surplus  of  £15,201. 
On  October  15,  1914,  the  preference  shareholders  gave 
their  consent  to  the  issue  of  additional  debenture  stock. 
It  was  stated  that  the  company's  cash  resources  have  been 
greatly  depleted  by  the  redemption  of  existing  debentures 
and  at  the  same  time  the  need  for  working  capital  has 
increased.  "For  some  time  past,  temporary  accommoda- 
tion has  been  obtained  from  the  company's  bankers  or 
others." 

As  to  the  record  of  American  industrial  combinations,  we 
cannot  do  better  than  present  the  following  abstract  from  the 
conclusions  ably  stated  in  Dewing's  "Corporate  Promotions 
and  Reorganizations." 

Nearly  all  the  large  industrial  combinations  have  been 
guilty  of  distributing  dividends  recklessly.  This  is  due 
in  part  to  the  extravagant  promises  on  the  strength  of 
which  securities  have  been  sold,  in  part  to  the  optimism 
of  promoters  and  directors,  in  part  to  a  desire  to  unload 
on  the  part  of  many  of  the  insiders. 

The  failures  of  the  Corn  Products  Co.,  The  American 
Malting  Company,  the  U.  S.  Realty  Co.  and  the  New 
England  Cotton  Yarns  Co.  were  the  direct  results  of  un- 
warranted payments  of  dividends.  The  U.  S.  Leather 
Co.,  the  National  Cordage  Co.,  the  National  Salt  Co.,  the 
Consolidated  Cotton  Duck  Co.,  and  the  International  Cot- 


DIVIDENDS 

ton  Mills  Corporation,  were  all  seriously  weakened  by- 
payment  of  dividends  at  the  expense  of  their  cash  posi- 
tion. 

In  the  case  of  the  American  Malting  Co.,  it  was 
proved  that  the  directors  must  have  declared  dividends 
without  having  before  them  any  statements  of  earnings. 
This  same  thing  probably  is  true  also  of  other  cor- 
porations. 

The  great  fluctuations  in  industrial  earnings  are  the 
chief  argument  against  the  use  of  bonds  by  industrials 
and  in  favor  of  conservatism  in  paying  dividends.  In 
1908  the  Westinghouse  Co.  had  gross  sales  of  $20,000,000 
and  a  deficit  of  $1,000,000.  In  1909,  gross  sales  of 
$30,000,000  and  net  profit  of  $3,000,000. 

These  fluctuations  involve  a  strong  tendency  to  bor- 
row on  short-term  notes  or  even  to  use  short-term  notes 
as  a  means  of  raising  money  with  which  to  pay  dividends. 

There  is  sound  reason  for  borrowing  on  short  time  in 
order  to  meet  fixed  charges  inasmuch  as  the  insolvency 
and  reorganization  of  the  company,  even  though  it  be 
only  temporary,  involves  a  severe  blow  to  its  credit  and 
trade.  For  instance,  after  the  panic  of  1907,  the  General 
Electric  Co.  had  a  loss  of  25%  in  its  business  and  the 
Westinghouse  Co.  37%.  The  explanation  seems  to  be  in 
the  failure  of  the  Westinghouse  Co. 

The  fact  that  insufficient  working  capital  exists  at  the 
time  of  the  insolvency  of  a  company  is  not  proof  that 
this  is  the  actual  cause  of  insolvency.  It  is  very  often 
true  that  the  lack  of  working  capital  is  itself  due  to  un- 
wise payments  on  account  of  fixed  charges  and  on  ac- 
count of  dividends. 

The  only  possible  reasons  which  can  lead  directors 
to  pay  out  unearned  dividends  are: 

1.  Ignorance. 

2.  A     false    belief    in     the    immediate     return    of 

prosperity. 

3.  A  desire  to  give  the  corporation  a  higher  stand- 

ing in  the  stock  market,  or  with  creditors,  than 
its  earnings  warrant. 


457 


458  INTERNAL  FINANCIAL  MANAGEMENT 

Scrip  Dividends 

Scrip  dividends  are  those  which  are  issued  in  the  form  of 
promises  to  pay  on  the  part  of  the  corporation.  These  prom- 
ises may  or  may  not  bear  interest.  They  usually  mature  at 
some  definite  date,  but  may  be  purely  indefinite  L  O.  U.'s, 
redeemable  at  the  option  of  the  corporation  or  redeemable 
within  a  certain  limit  of  time.  They  are  intended  usually  to 
meet  the  situation  which  has  been  briefly  described  above — 
that  of  a  corporation  which  has  made  a  good  showing  of  profits 
during  a  given  period,  but  is  not  in  sufficiently  strong  financial 
position  to  part  with  cash.  Payment  of  dividends  in  scrip  is 
sometimes  voted  in  order  to  avoid  spoiling  a  dividend  record 
that  would  otherwise  be  unbroken  or  as  a  temporary  expedient 
to  keep  up  dividends  on  preferred  stock.  After  the  first  West- 
inghouse  reorganization  in  1891,  the  first  dividend  of  i^% 
on  the  preferred  stock  was  issued  in  scrip,  so  as  not  to  reduce 
the  working  capital  immediately.  In  October,  19 14,  the  Cam- 
bria Steel  Company  desired  to  keep  up  its  regular  5%  divi- 
dends, but,  on  account  of  the  European  War,  the  directors 
did  not  think  it  wise  to  pay  out  in  cash  the  $562,500  required. 
On  account  of  the  dull  state  of  trade,  inventories  were  larger 
than  usual,  and  available  cash  resources  were  smaller  than 
usual.  The  directors  solved  the  difficulty  by  issuing  a  scrip 
dividend  bearing  5%  interest.  In  1910  the  Crucible  Steel 
Company  of  America  took  care  of  a  portion  of  the  accumulated 
dividends  on  its  preferred  shares  by  paying  10%  on  these 
shares  in  the  form  of  scrip  bearing  3%  interest. 

In  1 88 1  Henry  Villard  after  a  considerable  struggle  ob- 
tained control  of  the  Northern  Pacific  Railroad.  In  the  course 
of  his  fight  for  control  he  had  advocated  the  payment  of  divi- 
dends on  the  company's  preferred  stock,  and  in  the  first  annual 
report  after  his  election  as  president  it  was  stated  that  the 
surplus  earnings  since  1875,  amounting  to  $4,667,490,  had 
been  used  for  construction  and  were  properly  due  to  the  pre- 


DIVIDENDS  459 

ferred  stockholders.  On  the  strength  of  his  statement,  the 
directors  declared  a  dividend  to  the  preferred  stockholders 
of  11%,  which  was  not  paid  in  cash  but  in  the  form  of  5-year 
6%  obligations  of  the  company  redeemable  after  one  year  at 
the  option  of  the  company.  When  this  scrip  fell  due  in  1887, 
the  company  was  in  no  condition  to  pay  it  in  cash.  It  there- 
fore imposed  on  its  property  a  third  mortgage  amounting  to 
$12,000,000,  over  $3,000,000  of  which  was  used  to  meet  the 
maturing  dividend  scrip.* 

The  payment  of  accumulated  dividends  on  preferred  shares 
has  been,  in  a  number  of  cases,  taken  care  of  in  this  manner. 
The  Trenton  Potteries  Company  has  outstanding  $411,570  of 
"funding  certificates"  which  were  issued  to  stockholders  who 
exchanged  their  8%  cumulative  preferred  for  a  new  issue  of 
8%  non-cumulative  preferred.  These  stockholders  received 
44%,  being  the  amount  of  their  dividends  in  arrears,  in  the 
form  of  "funding  certificates." 

Stock  Dividends 

A  form  of  dividend  payment  which  appears  to  be  growing 
in  popularity  is  the  issuance  of  stock  representing  profits  not 
otherwise  distributed.  Stock  dividends  are  issued  for  any  of 
three  reasons : 

1.  In  order  to  give  to  stockholders  tangible  evidence  of 

the  increasing  value  of  their  property, 

2.  In  order  to  maintain  the  market  value  of  the  stock 

at  a  price  which  will  make  it  more  readily  market- 
able. 

3.  In  order  to  veil  huge  profits  in  prospect  by  making 

it  possible  to  declare  a  small  or  moderate  dividend 
on  a  large  amount  of  stock  instead  of  a  very  high 
dividend  on  a  small  amount  of  stock. 


^Daggett's   "Railroad   Reorganizations,"  pp.   274-276. 


460 


INTERNAL   FINANCIAL   MANAGEMENT 


These  three  motives  are  not  always  clearly  distinguished; 
one  of  the  three  is  usually  predominant.  It  will  be  agreed  by 
everyone  that  the  payment  of  a  stock  dividend  does  not  in 
itself  add  anything  to  the  assets  of  the  stockholders  who  re- 
ceive the  dividend.  If  the  owner  of  one  share  of  stock  in  a 
corporation  with  $100,000  stock  outstanding,  is  given,  we  will 
say,  a  900%  stock  dividend,  so  that  he  becomes  the  owner 
of  10  shares  in  a  $1,000,000  corporation,  his  real  standing 
has  not  been  changed  in  the  slightest.  He  remains,  just  as  he 
was  at  the  beginning,  the  owner  of  1/1,000  interest  in  the 
enterprise.  His  only  real  gain  comes  in  the  mental  satisfac- 
tion that  he  receives  if  he  continues  to  hold  his  stock  indefi- 
nitely (and  this  is  by  no  means  a  negligible  factor),  or  in  the 
easier  marketability  of  his  holdings  if  he  wishes  to  sell  them. 
Even  the  third  motive  does  not  affect  the  shareholder's  income 
but  merely  the  nominal  rate  of  dividend  on  his  holdings. 

A  clear  illustration  of  the  predominance  of  the  first  motive 
is  to  be  found  in  the  recent  announcement  of  a  10%  stock 
dividend  on  the  part  of  the  Corporation  of  Riker  and  Hege- 
man,  a  company  which  owns  a  chain  of  drug  stores  which  is 
controlled  by  interests  associated  with  the  United  Cigar  Stores 
Company.  During  the  process  of  building  up  this  last-named 
company,  no  cash  dividends  were  declared  but  the  increasing 
surplus  was  represented  by  frequent  declarations  of  stock  divi- 
dends. A  number  of  other  companies  have  adopted  the  prac- 
tice of  paying  regular  stock  dividends  in  addition  to  cash 
bonuses.  The  annual  4%  stock  dividends  of  the  Proctor  and 
Gamble  Company  have  been  referred  to.  The  American  Light 
and  Traction  Company  has  for  several  years  declared  regular 
quarterly  dividends  oi  2yi%  in  cash  and  2^%  in  stock.  The 
United  Light  and  Railways  Company  is  paying  quarterly 
dividends  of  1%  in  common  stock.  The  American  Gas  and 
Electric  Company  and  the  City  Service  Company  have  also 
paid  small  stock  dividends.     It  may  be  assumed  that  the 


DIVIDENDS 


461 


practice  in  the  case  of  public  utility  companies  has  in  view 
the  desirability  of  keeping-  down  the  rate  of  cash  dividends 
to  a  moderate  amount.  Much  the  same  plan  has  been  followed 
by  some  of  the  English  public  utility  companies. 

Stock  dividends  which  are  intended  to  represent  large 
accumulations  of  surplus  that  could  not  be  disbursed  in  cash 
have  been  especially  frequent  of  late  years  among  automobile 
companies.  The  Packard  Motor  Company  is  said  to  have 
paid  no  cash  dividends  on  its  common  stock,  which  is  closely 
held,  but  did  pay  in  19 13  a  40%  stock  dividend  on  its  $5,000,- 
000  common  previously  outstanding,  bringing  that  issue  up 
to  $7,000,000.  The  General  Motors  Company  not  long  ago 
declared  150%  stock  dividend.  The  record  among  motor 
companies  up  to  the  present  time  is  held  by  the  Chalmers 
Company,  which  in  19 10  paid  a  stock  dividend  of  900%. 
Even  this  record,  however,  is  likely  to  be  overshadowed  by  the 
action  on  the  part  of  the  Ford  Motor  Company,  which  has 
been  announced  but  not  yet  put  into  effect,  providing  for  a 
stock  dividend  of  2,400%  with  a  view  to  raising  its  outstand- 
ing capital  stock  from  $2,000,000  to  $50,000,000. 

The  record  of  the  Singer  Sewing  Machine  Company,  with 
its  various  stock  dividends  of  100  and  200%,  has  been  pre- 
viously mentioned.  Other  instances  are  those  of  the  Pabst 
Brewing  Company,  which  paid  out  an  issue  of  $2,000,000  7% 
cumulative  preferred  in  the  form  of  a  20%  stock  dividend  to 
its  common  stockholders;  the  Pacific  Mills,  which  increased  its 
capital  stock  from  $3,000,000  to  $12,000,000  by  the  declara- 
tion of  a  300%  stock  dividend,  at  the  same  time  reducing  the 
par  value  of  its  shares  from  $1,000  to  $100;  the  American 
Rolling  Mills  Company,  which  paid  a  stock  dividend  of 
33  1/3%  ii^  1907  ^^^  another  stock  dividend  of  100%  in  1909; 
the  Adams  Express  Company  which  in  1907  paid  a  special 
dividend  in  the  form  of  4%  collateral  trust  bonds ;  the  George 
E.  Keith  Company,  which  in  19 13  issued  $4,000,000  7%  cumu- 


462  INTERNAL   FINANCIAL   MANAGEMENT 

latlve  preferred  as  a  200%  stock  dividend;  and  the  Midvale 
Steel  Company  which  in  19 10  declared  a  1,200%  stock  divi- 
dend increasing  the  outstanding  issue  from  $750,000  to 
$9,750,000. 

It  should  be  remarked  at  this  point  that  the  issuance  of 
preferred  stock  or  of  bonds  in  payment  of  dividends  is  a  device 
that  may  be  regarded  as  in  one  sense  actually  increasing  the 
property  interests  of  each  stockholder.  Yet,  after  all,  each 
shareholder  is  lifting  himself  by  his  own  boot-straps ;  whatever 
he  gains  in  the  form  of  a  prior  claim  for  interest  or  preferred 
dividends,  he  has  gained  at  the  expense  of  his  common  share- 
holdings which  are  thereby  reduced  to  a  correspondingly  lower 
level.  Even  in  these  instances,  therefore,  the  statement  that 
a  stock  dividend  does  not  in  itself  change  the  real  value  of  a 
stock  owner's  holdings  is  substantially  correct.  The  effect 
of  an  increase  in  stock  which  tends  to  reduce  the  market  value 
of  each  share  and  thereby  to  make  it  more  readily  marketable, 
has  been  discussed  in  earHer  chapters.  It  is  sufficient  here  to 
give  one  illustration. 

In  1892  the  National  Cordage  Company,  which  had  been 
organized  in  1887,  was  at  the  height  of  its  prosperity  and  its 
stock  was  one  of  the  leading  securities  on  the  New  York  Stock 
Exchange.  In  the  autumn  of  that  year,  a  member  of  the  Ex- 
change remarked  to  President  Waterbury,  "Your  stock  is 
selling  too  high,"  meaning  that  for  speculative  purposes  it 
would  be  better  to  have  the  stock  selling  at  $70  a  share  rather 
than  at  $140.  President  Waterbury  presented  the  idea  to  the 
board  of  directors  who  decided  to  issue  in  January,  1893,  a 
100%  stock  dividend.  The  book  value  of  the  subsidiary  plants 
was  marked  up  to  correspond  with  the  inflation  of  the  capital 
stock.  Through  the  payment  of  the  dividend  the  outstanding 
stock  was  increased  from  $10,000,000  to  $20,000,000.  The 
directors  explained  that  the  new  issue  was  "to  represent  about 
$10,000,000  of  assets  acquired  by  the  company  since  its  forma- 


DIVIDENDS 


463 


tlon,  and  which  it  is  the  policy  of  the  company  to  hold  intact." 
The  directors  also  stated  that  it  would  be  the  company's  policy 
to  pay  dividends  of  7%  on  the  new  common  stock.  A  little 
over  a  year  later  the  company  was  in  the  hands  of  receivers.* 

Legal  Rules  Affecting  Dividends 

It  would  be  inadvisable  to  close  this  chapter  without  calling 
attention  to  some  well-established  legal  principles  which  should 
always  be  kept  in  view.  Perhaps  the  most  important  of  these 
principles  is  that  dividends  shall  be  paid  only  out  of  surplus 
and  never  out  of  capital.  The  Corporation  Act  of  New  Jersey 
provides  that  directors  who  take  part  in  such  action,  or  who 
do  not  enter  a  protest  within  a  reasonable  period,  shall  be 
personally  liable  during  a  period  of  six  years  following  the 
payment  of  such  dividends.  The  best-known  case  which  has 
established  and  emphasized  this  principle  is  that  of  the 
American  Malting  Company.  During  the  first  year  of  the 
existence  of  this  company  the  directors  declared  cash  dividends, 
apparently  on  the  strength  of  "anticipated"  profits  which  were 
included  in  the  income  account.  After  the  facts  became 
known,  suits  were  brought  by  stockholders  both  in  New  York 
and  New  Jersey,  and  in  both  states  the  suits  were  decided  in 
favor  of  the  stockholders.  After  litigation  lasting  almost  five 
years,  the  matter  was  settled  by  the  payment  on  the  part  of 
individual  directors  of  $500,000,  $340,000  of  which  went  into 
the  treasury  of  the  company  and  $160,000  to  the  plaintiffs  for 
the  expenses  of  their  suits. 

Another  important  legal  principle  is  that  dividends  once 
declared  become  an  indebtedness  of  the  corporation  to  the 
stockholders  and  cannot  afterward  be  rescinded  by  the  direc- 
tors. It  is  even  held  in  most  jurisdictions  that  dividends  once 
declared  no  longer  belong  to  the  corporation  but  have  become 
the  property  of  the  stockholders  as  individuals. 


•Dewing's  "Corporate  Promotions  and  Reorganizations,  p.  132. 


464  INTERNAL   FINANCIAL   MANAGEMENT 

There  are  numerous  special  requirements  and  limitations 
contained  in  the  constitutions  of  the  various  states.  As  an 
example,  attention  may  be  called  to  a  law  in  the  State  of 
Massachusetts  forbidding  the  issuance  of  stock  and  scrip  divi- 
dends by  public  utility  companies,  which  reads  as  follows : 

No  company  shall  declare  any  stock  or  scrip  dividend 
or  divide  the  proceeds  of  any  sale  of  stock  or  scrip 
among  its  stockholders;  nor  shall  any  company  create 
any  additional  new  stock  or  issue  certificates  thereof  to 
any  person  unless  the  par  value  of  the  share  so  issued  is 
first  paid  in  cash  into  its  treasury. 


CHAPTER    XX 

SURPLUS 

Surplus  Reserve  and  Surplus  Fund 

The  final  item  in  our  formula  for  income  consists  of 
"balance  carried  to  the  permanent  surplus  account."  It  is 
sometimes  labeled  ''surplus  for  the  period,"  but,  inasmuch  as 
this  phrase  is  applied  also  to  what  we  have  called  "balance, 
applicable  to  dividends  and  surplus,"  it  is  somewhat  misleading 
and  for  this  reason  is  not  used.  Much  confusion  of  thought 
arises  out  of  the  continual  inaccuracies  and  variations  in  the 
application  of  such  terms  as  "income,"  "profits,"  "earnings," 
and  "surplus."  Until  the  general  usage  of  this  and  many  other 
business  terms  becomes  more  clearly  settled,  it  will  be  impos- 
sible wholly  to  avoid  this  confusion. 

Two  terms  which  should  be  clearly  distinguished,  however, 
are  "surplus  reserve"  and  "surplus  fund."  Surplus  reserve, 
more  frequently  referred  to  simply  as  "surplus,"  is  in  effect 
simply  an  account  or  a  group  of  accounts  kept  in  the  company's 
books  which  show  the  value  of  the  equity  belonging  to  stock- 
holders over  and  above  the  par  value  of  the  outstanding  shares. 
Like  many  other  accounts,  surplus  is  in  part  the  result  of  esti- 
mate or  of  a  series  of  estimates.  If  the  estimate  is  judged 
by  the  directors  or  ofBcers  of  the  corporation  to  be  wrong,  it 
may  be  changed  by  a  mere  entry  in  the  company's  journal. 
An  instance  has  been  cited  in  the  preceding  chapter  of  the 
marking  up  of  the  book  value  of  the  plants  and  other  assets 
of  the  National  Cordage  Company  by  $10,000,000,  in  order 
to  create  on  the  credit  side  of  the  balance  sheet  an  increase  in 
the  surplus  account  of  $10,000,000  from  which  a  stock  dividend 
could  be  paid.    An  instance  has  previously  been  given  also  of 

465 


466  INTERNAL  FINANCIAL  MANAGEMENT 

a  publishing  company,  the  good-will  account  of  which  was 
increased  by  $300,000  in  order  to  inflate  the  surplus  account 
by  a  like  amount.  In  the  section  following,  the  various  methods 
through  which  a  surplus  account  may  be  built  up  are  reviewed. 
For  the  immediate  purpose,  it  is  sufficient  to  emphasize  the 
point  that  surplus  reserve  is  in  itself  purely  a  more  or  less 
formal  and  inconclusive  appraisal  of  the  shareholders'  equitable 
interest  in  the  corporation  above  the  par  value  of  their  hold- 
ings. 

A  surplus  fund,  on  the  other  hand,  is  an  asset  account 
which  can  be  properly  used  only  to  designate  certain  sums  of 
cash,  of  securities,  or  of  other  property,  which  are  set  aside, 
not  for  use  within  the  business,  but  for  some  supplementary 
purpose  such  as  the  retirement  of  certain  securities  or  for  the 
general  protection  and  insurance  of  the  shareholders  against 
loss.  The  surplus  fund  seldom  exists  in  this  country  under 
this  title.  It  not  infrequently  happens,  however,  that  a  com- 
pany carries  holdings  of  cash  or  securities  not  needed  in  its 
business  and  set  aside  for  a  special  purpose  which  could 
properly  be  labeled  ''surplus  fund,"  if  it  were  so  desired. 
Surplus  reserve  and  surplus  fund,  even  where  they  coexist, 
are  by  no  means  necessarily  equivalent. 

In  this  volume,  and  in  customary  usage,  the  word  "surplus" 
when  used  alone  without  qualification,  refers  to  surplus  reserve. 
The  fact  that  it  refers  to  a  credit  account — for  which  the 
corporation  is  responsible  to  its  shareholders — and  not  to  an 
asset  or  to  any  group  of  assets,  should  be  borne  clearly  in 
mind. 

Five  Sources  of  Surplus 

We  have  spoken  of  surplus  in  the  preceding  chapter  as] 
if  it  were  always  derived  from  earnings.  Ordinarily  this  is] 
so  but  surplus  may  result  from  other  causes  as  well.  Fivej 
possible  sources  of  surplus  are  given  below : 


SURPLUS 


467 


1.  Inheritance  from  previously  absorbed  corporations. 

2.  Sale  of  securities  above  par. 

3.  Sale  of  assets  above  their  book  value. 

4.  Revaluation  of  assets. 

5.  Accumulation  out  of  earnings. 

The  first  source  is  uncommon,  inasmuch  as  most  new  cor- 
porations, even  those  which  take  over  going  businesses,  carry 
the  assets  which  they  acquire  at  their  full  cost  value — no  njore 
and  no  less — so  that  they  start  with  neither  a  surplus  nor  a 
deficit;  and  this  would  seem  ordinarily  to  be  the  correct  pro- 
cedure. However,  there  are  occasional  exceptions.  In  1914 
the  Dominion  Linens  Company  of  Canada  was  organized  with 
an  issued  capital  stock  of  $250,000.  The  company,  according 
to  a  statement  prepared  by  the  well-known  accounting  firm 
of  Price,  Waterhouse  and  Company,  showed  assets  of  $267,- 
684.  After  deducting  a  small  amount  of  accounts  payable 
there  was  left  a  surplus  at  the  outset  of  $14,138.  It  should 
be  remarked,  however,  that  among  the  assets  was  one  item  of 
"good-will,  trade-marks,  etc.,''  valued  at  $20,000.  A  surplus 
of  this  nature  can  hardly  escape  the  suspicion  of  being  more 
or  less  fictitious.  It  is  scarcely  safe  to  assume  that  the  assets 
acquired  are  worth  more  than  what  was  paid  for  them.  The  fact 
that  these  assets  may  have  been  carried  on  the  books  of  the 
previously  existing  companies  at  a  higher  book  value  than  was 
paid  for  them,  has  no  bearing  on  the  case  so  far  as  the  new 
company  is  concerned. 

The  second  source  consists  of  the  sale  of  securities  above 
par.  In  such  a  case  the  corporation  receives  a  greater  sum 
than  the  nominal  value  of  the  obligations  or  the  shares  which 
it  issues.  This  additional  sum  may  be  carried  to  an  account 
called  "Premium  on  Securities"  or  some  such  title,  or  it 
may  be  and  frequently  is  credited  direct  to  surplus.  It  is  clear 
that  a  surplus  which  arises  in  this  form  is  hardly  to  be  regarded 


468  INTERNAL   FINANCIAL  MANAGEMENT 

as  a  proper  source  of  dividends,  inasmuch  as  the  premium  on 
shares  or  bonds  is  in  reaHty  a  contribution  to  the  capital  assets 
of  the  company.  In  handhng  transactions  of  this  type,  in- 
dustrial and  railroad  corporations  might  profitably  take  a  leaf 
from  the  practice  of  banks.  In  organizing  new  banks  it  is 
frequently  agreed  that  every  $ioo  share  shall  be  sold  at  $125 
or  $150,  or  some  other  amount  above  its  nominal  value,  so  as 
to  create  a  surplus  account  at  the  outset.  As  the  bank  earns 
profits,  these  are  carried,  not  to  the  Surplus  account,  but  to 
an  account  entitled  "Undivided  Profits"  out  of  which  dividends 
are  declared.  From  time  to  time  the  directors  may,  more  or 
less  arbitrarily,  transfer  whatever  sums  they  decide  upon  from 
the  Undivided  Profits  account  to  the  Surplus  account.  It  is 
understood  that  credits  to  surplus  are  not  intended  to  be  dis- 
tributed, but  are  regarded  as  an  integral  part  of  the  permanent 
capital  of  the  institution. 

The  third  source  is  through  the  sale  of  permanent  assets, 
which  are  not  intended  for  trading  purposes,  for  a  sum  above 
their  book  value.  Frequently  assets  are  written  down  over 
a  long  period  until  their  book  valuation  becomes  only  a  small 
portion  of  their  real  value.  To  take  an  extreme  and  notable 
instance,  the  immensely  valuable  property  of  the  Bank  of 
England  on  Threadneedle  Street,  London,  does  not  appear  on 
the  balance  sheet  of  the  corporation  at  all. 

The  fourth  source  of  surplus  is  the  revaluation  of  assets 
which  have  not  been  sold  but  are  intended  to  be  retained.  This 
is  a  tempting  expedient  for  a  company  which  is  running  at  an 
operating  loss  or  with  very  small  profits,  and  yet  is  under 
pressure  to  make  a  satisfactory  showing.  In  the  latter  part 
of  1902,  the  management  of  the  United  States  Leather  Com- 
pany decided  to  reappraise  certain  large  areas  of  hemlock  bark 
land  which  had  been  bought  at  a  fair  market  valuation  in 
1893.  Since  then  prices  of  timber  and  of  bark  had  gone  up. 
A  committee  of  directors  reported  in   1903   that  the  bark 


SURPLUS  469 

property  was  worth  about  $14,000,000  more  than  its  book 
value.  In  order  to  show  this  increased  value  on  the  books, 
the  officials  incorporated  the  Central  Pennsylvania  Lumber 
Company  (all  of  the  stock  of  which  was  owned  by  the  United 
States  Leather  Company)  ;  the  lumber  company  bought  the 
timber  (only)  on  the  revalued  bark  land,  for  which  it  gave 
$10,000,000  of  first  mortgage  bonds.  It  was  intended  to  pay 
dividends  on  the  preferred  stock  out  of  this  suddenly  acquired 
surplus.  However,  the  original  contract  between  the  corpora- 
tion and  its  preferred  shareholders  stated  that  dividends  should 
be  paid  only  out  of  net  earnings,  and  the  revaluation  of  the 
timber  lands  could  hardly  be  construed  as  "net  earnings."  On 
the  other  hand,  it  was  argued  that  the  timber  had  actually 
been  sold  and  securities  had  been  received  in  payment.  In 
the  end,  the  question  was  settled  without  bringing  before  the 
court  the  dispute  as  to  whether  the  formation  of  the  subsid- 
iary company  and  the  transfer  of  its  bonds  was  or  was  not 
merely  a  fiction. 

The  handling  of  timber  properties  so  as  to  present  a  fair 
statement  of  the  results  that  are  actually  achieved,  always 
raises  difficult  questions.  Taxes  assessed  against  timber  lands 
are  frequently  charged  into  an  asset  account  in  order  to  show 
the  total  carrying  charges  of  the  property.  The  continual  rise 
in  land  values,  and  especially  in  the  values  of  timber  proper- 
ties, has  been  so  regular  that  this  method  has  seldom  been 
found  disappointing.  As  to  the  revaluation  of  timber  proper- 
ties, it  is  thought  by  some  authorities  that  there  is  no  special 
objection  in  this  case,  provided  the  surplus  thus  created  is  put 
into  a  separate  account  and  not  treated  as  a  part  of  the  general 
surplus  available  for  dividends. 

The  question  as  to  whether  assets  should  be  revalued  or 
not  frequently  arises,  also,  in  the  cases  of  banks  and  other 
financial  institutions  which  own  large  amounts  of  securities. 
On  a  rising  market  these  securities  may  frequently  have  a 


470  INTERNAL   FINANCIAL   MANAGEMENT 

market  value  much  higher  than  their  original  cost,  and  the 
officers  or  directors  of  the  company  may  desire  that  this  extra 
value  should  be  shown  on  the  books  and  credited  to  surplus. 
Independent  accountants  are  usually  strongly  averse  to  this 
practice,  on  the  ground  that  it  makes  a  fictitious  showing  of 
profits.  If  the  securities  are  actually  sold  and  a  profit  is 
realized,  then  this  profit  will  naturally  go  into  a  surplus 
account.  Otherwise  it  is  regarded  as  sound  and  correct  to 
carry  them  at  their  cost  valuation.  It  is  not,  however,  incon- 
sistent with  this  principle  to  insist  that  declinations  in  market 
value  should  be  written  off  against  surplus. 

It  must  be  remembered  that  the  surplus  account  is  at  best* 
only  an  estimate  and  that  it  is  highly  desirable  to  keep  this 
estimate  always  well  within  conservative  limits.  In  operating 
an  enterprise  and  selling  its  products,  a  valuable  trait  is  the 
optimism  that  will  carry  a  man  forward  through  discourage- 
ments and  temporary  defeats.  But  in  estimating  the  results 
and  forecasting  the  future,  it  is  necessary  above  all  to  be 
cautious  and  even  skeptical. 

In  general  it  is  safe  to  say  that  the  instances  in  which  an 
upward  revaluation  of  the  permanent  assets  of  a  company  is 
permissible,  are  highly  exceptional  and  that  in  these  excep- 
tional cases  the  surplus  thus  created  should  always  be  plainly 
earmarked  so  that  there  will  be  no  mistaking  its  source. 

The  fifth  and  most  important  source  of  surplus  consists 
of  savings  out  of  the  company's  earnings.  We  have  already 
seen  that  every  year  should  yievld  a  balance  of  profits  above  all 
fixed  charges  and  above  all  dividends.  This  balance,  if  credited 
to  surplus  year  after  year,  will  in  time  build  up  a  large  surplus 
account.  If  the  building  up  of  this  account  is  accompanied 
by  consistent  writing  down  of  all  assets  of  doubtful  value,  the 
balance  sheet  of  the  company  will  in  time  show  an  increasing 
equity  on  the  part  of  the  shareholders  of  a  very  substantial 
nature.     If  surplus  were  always  built  up  only  out  of  con- 


SURPLUS 


471 


servatively  estimated  earnings,  it  could  be  safely  accepted  as 
a  fairly  accurate  measure  of  the  real  prosperity  and  solidity 
of  the  business.  But  surplus  which  comes  from  the  other 
sources  that  have  been  named — even  though  it  may  be  a 
genuine  surplus  which  has  been  realized — gives  no  convincing 
evidence  of  earning  power  or  of  conservative  and  level-headed 


management. 


The  term  "surplus,"  therefore,  in  itself  means  little.  It 
should  always  be  examined  with  care  and  its  origin  should  be 
determined  before  basing  upon  it  any  judgment  as  to  the  pros- 
perity or  good  management  of  the  company  which  shows  it. 

We  have  now  to  consider  what  principles  should  be  fol- 
lowed in  accumulating  surplus  out  of  earnings  and  what  uses 
should  be  made  of  the  increased  assets  which  are  represented 
in  the  surplus  account. 

Accumulating  Surplus 

In  discussing  the  desirability  of  establishing  and  maintain- 
ing a  regular  rate  of  dividends  it  has  been  suggested  that  the 
only  safe  principle  to  follow  is  to  fix  the  dividend  rate  below 
the  estimated  minimum  earnings,  thus  making  sure  that  it  will 
be  kept  up  year  after  year.  This  leaves  all  the  extra  profits 
of  good  years  to  go  into  surplus.  If  the  company's  business 
is  of  a  highly  stable  nature  so  that  the  fluctuations  in  earnings 
are  slight,  it  follows  that  the  extra  earnings  of  the  good  years 
will  be  relatively  small  and  surplus  will  accumulate  slowly.  If 
the  business,  on  the  other,  hand,  fluctuates  a  great  deal,  these 
dividends  will  absorb  only  a  small  proportion  of  average  earn- 
ings, and  the  greater  portion  will  remain  as  a  credit  to  the 
surplus  account. 

This  principle,  therefore,  automatically  results  in  piling 
up  a  surplus  almost  in  direct  proportion  to  the  degree  of  fluc- 
tuation of  earnings.  And  this  is  as  it  should  be.  A  company 
engaged  in  a  business  which  enjoys  steady  earnings  will  have 


472  INTERNAL   FINANCIAL  MANAGEMENT 

no  trouble  in  raising  fresh  capital  for  any  extensions  that  may 
be  required  and  which  can  be  shown  to  be  clearly  profitable. 
It  is  not  necessary,  therefore,  that  new  capital  should  be 
provided  by  savings  out  of  earnings.  On  the  other  hand,  a 
company,  the  earnings  of  which  fluctuate  widely,  is,  on  the  face 
of  it,  engaged  in  a  speculative  business  and  cannot  easily  secure 
fresh  capital  on  favorable  terms.  Only  through  accumulations 
out  of  earnings  can  the  business  be  extended  and  stabilized. 

The  principle  that  has  just  been  stated  is,  of  course,  put 
forward  only  as  a  general  rule  which  is  subject  to  innumerable 
qualifications  and  exceptions.  First  of  all,  it  may  be  impossible 
to  determine  in  advance  what  the  minimum  earnings  are  likely 
to  be.  Second,  it  may  be  desirable  to  use  some  discretion  and 
diplomacy  in  dealing  with  stockholders  and  to  satisfy  their 
wishes  from  time  to  time  by  distributing  a  portion  of  the  extra 
earnings  of  prosperous  years.  For  both  these  reasons  the 
strict  and  inflexible  application  of  the  rule  that  has  been  stated 
is  not  always  to  be  insisted  upon.  Most  well-managed 
companies  are  satisfied  if  they  reach  some  reasonable 
approximation  in  applying  the  rule. 

There  is  another  qualification,  also,  of  still  greater  im- 
portance. In  all  that  has  been  said  as  to  this  rule,  it  has  been 
taken  for  granted  that  fresh  capital  can  be  taken  into  any 
business  enterprise  and  used  as  profitably  as  the  original 
capital.  In  a  great  many  cases  this  is  true,  especially  if  the 
fresh  capital  is  not  dumped  upon  the  company  in  one  or  two 
big  lots  secured  through  the  sale  of  securities,  but  is  gradually 
•  added  year  after  year  and  thus  made  available  for  betterments 
and  extensions  that  are  actually  needed.  However,  even  in 
those  cases  there  may,  after  a  time,  come  a  limit  to  the  de- 
velopment of  the  company  beyond  which  fresh  capital  cannot 
be  profitably  applied.  When  this  limit  is  reached,  it  is  no 
longer  desirable  to  accumulate  surplus  with  rapidity.  If  earn- 
ings have  not  at  that  time  been  stabilized,  it  may  be  good  policy 


SURPLUS  473 

to  pay  out  most  of  the  income  year  after  year  in  dividends, 
allowing  the  dividends  to  fluctuate  in  close  relation  to  the  in- 
come. Or  it  may  be  adjudged  better  to  fix  the  dividend  rate 
at  about  the  average  anticipated  income,  in  which  case  extra 
profits  of  the  good  years  will  be  invested  outside  the  company 
in  short-term  securities  which  will  be  sold  when  necessary  in 
order  to  provide  cash  or  dividends  during  the  lean  years.  It 
is  perhaps  due  to  the  fact  that  opportunities  for  expansion  of 
most  successful  enterprises  in  the  United  States  are  almost 
unlimited,  that  so  much  emphasis  has  been  laid  in  our  financial 
practice  on  the  necessity  of  making  large  savings  out  of  annual 
profits;  whereas  in  European  countries,  where  the  oppor- 
tunities for  expansion  are  more  limited,  the  custom  prevails 
of  paying  out  most  of  the  annual  earnings  in  dividends  and  of 
relying  upon  fresh  issues  of  securities  to  provide  whatever 
new  capital  is  needed. 

Policies  of  Various  Companies 

In  connection  with  the  preceding  section,  the  Hendee  Manu- 
facturing Company  may  be  cited  as  a  typical  example  of 
American  practice;  this  is  a  relatively  small  but  prosperous, 
rapidly  growing,  and  evidently  well-managed  corporation, 
which  specializes  in  the  production  of  motor-cycles.  In  the 
year  ended  August  31,  19 14,  this  company  earned  profits  of 
$711,566,  out  of  which  it  paid  dividends  of  only  $131,250;  a 
sinking  fund  of  $150,000  for  the  retirement  of  preferred 
stock  was  also  deducted,  leaving  the  amount  of  profits  for  the 
year  carried  into  the  surplus  account,  $430,316. 

By  way  of  contrast  we  may  take  at  random  a  well-known 
and  well-managed  English  company — Harrison  and  Cros- 
field,  Limited — which  has  been  earning  profits  of  about  the 
same  amount  as  the  Hendee  Company.  During  the  four  years 
1910-1914  net  profits  averaged  about  £150,000,  from  which 
have  been  normally  deducted : 


474  INTERNAL   FINANCIAL   MANAGEMENT 

Dividends  on  5^%  cumulative  preferred  shares.  £27,500 
Dividends  on  the  10%  preferred  ordinary  shares.  £30,000 

Dividends  on  management  shares £30,000  to  £67,500 

Approximate  remaining  balance £60,000  to  £25,000 

However,  this  balance  is  reckoPxed  before  providing  re- 
serves for  depreciation  and  other  charges  and  after  they  have 
been  taken  out  there  is  ordinarily  remaining  only  a  small  ac- 
cumulation of  surplus.  This  is  cited,  not  as  an  unusual,  but 
as  a  typical,  case  of  English  practice. 

Sometimes  the  American  policy  is  carried  to  an  extent 
which  creates  a  remarkable  disproportion  between  the  capital 
account  and  the  surplus  account.  The  Storey  and  Clark 
Piano  Company,  for  example,  which  owns  fifteen  retail  stores, 
is  reported  to  have  outstanding  capital  of  $100,000  and  a 
surplus  of  over  $2,000,000.  The  Ford  Motor  Company  at 
the  end  of  the  fiscal  year  19 14,  had  capital  stock  of  $2,000,000 
and  a  surplus  of  nearly  $49,000,000.  However,  these  unusual 
relations  are  to  be  ascribed,  not  so  much  to  an  unusual  amount 
of  savings  out  of  income,  on  the  part  of  these  two  corporations, 
as  to  their  omission  to  follow  the  usual  practice  of  revising 
their  capitalization  from  time  to  time  to  conform  to  the  in- 
creasing assets  and  earnings.  Most  prosperous  American 
industrials  save  the  greater  part  of  their  earnings,  but  through 
stock  dividends  and  other  processes  of  "watering,"  their  pros- 
perity appears  in  the  form  of  enlarged  capital  accounts  rather 
than  enlarged  surplus  accounts. 

The  Pennsylvania  Railroad  Company,  in  applying  the 
principle  that  has  been  stated  in  the  preceding  section,  has 
endeavored  for  some  years  to  put  a  dollar  into  the  surplus 
account  for  every  dollar  that  has  been  paid  in  dividends.  In 
other  words,  it  aims  to  divide  its  balance  of  earnings,  after 
providing  for  fixed  charges,  about  evenly  between  dividends 
and  surplus.  During  the  eleven  years  ended  June,  191 3,  the 
company  maintained  dividends  at  6%  with  an  occasional  extra 


SURPLUS 


475 


dividend  of  i%.     During  these  same  years  the  additions  to 
surplus  as  compared  with  capital  stock  were  as  follows: 


1903 

3.45% 

1909 

5.79% 

1904 

4.42% 

1910 

6.64% 

1905 

5.71% 

1911 

4-47% 

1906 

7.92% 

1912 

4-24% 

1907 

6.76% 

1913 

3-97% 

1908 

5.91% 

In  spite  of  the  Pennsylvania's  accumulating  surplus  and  highly 
conservative  policy  the  price  of  the  stock  has  been  in  recent 
years  seeking  a  lower  level.  This  is  probably  due  in  part  to 
general  economic  conditions,  but  in  part  also  to  the  apparent 
belief  on  the  part  of  investors  that  the  surplus  of  the  company, 
great  as  it  is,  is  no  more  than  is  required  to  secure  the  main- 
tenance of  the  present  rate  of  dividends. 

Railroad  companies  under  English  influence,  no  matter 
where  they  may  be  located,  seldom  accumulate  any  considerable 
amount  of  surplus.  For  instance,  the  Buenos  Ayres  Great 
Southern  Railway,  in  191 3,  out  of  a  total  available  surplus 
for  the  year  of  £3,157,500,  after  paying  interest  and  dividends, 
carried  forward  only  £473,600.  The  next  year,  out  of  £2,891,- 
200  the  company  carried  forward  only  £316,100.  In  191 3  the 
Buenos  Ayres  Great  Western,  out  of  net  revenue  of  £1,246,500, 
carried  forward  £125,100.  In  1914,  out  of  £1,041,400,  they 
carried  forward  only  £47,100.  The  Central  Uruguay  Rail- 
road, out  of  available  surplus  of  £384,500,  in  1913,  carried 
forward  £29,900;  in  1914,  out  of  $329,900  it  carried  forward 
£54,100.  In  all  these  cases,  the  railroads  were  paying  fair  to 
good  rates  of  dividends  on  their  ordinary  shares. 

"Rainy-Day  Funds" 

Some  companies  make  it  a  practice  to  invest  a  portion  of 
their  saved  earnings,  in  securities  or  readily  salable  prop- 


476 


INTERNAL   FINANCIAL   MANAGEMENT 


erty  held  outside  the  business,  as  an  insurance  that  dividends 
will  be  maintained.  This  practice  is  much  more  common 
abroad  than  in  this  country,  although  not  wholly  unknown 
here.  At  the  end  of  the  fiscal  year  1914,  the  directors  of 
George  Newnes,  Limited,  an  English  publishing  house,  pro- 
posed to  carry  £25,000  out  of  the  profits  of  the  year  to  a 
"Dividend  Equalization  Account"  which  would  then  amount 
to  £50,000.  It  is  to  be  presumed,  though  it  is  not  so  stated, 
that  this  "Dividend  Equalization  Account"  would  be  repre- 
sented on  the  asset  side  of  the  balance  sheet  by  a  surplus  fund 
consisting  of  cash  or  securities  set  aside  and  available  for 
quick  sale  in  case  of  need.  Unless  there  are  assets  available 
for  quick  realization  in  cash,  corresponding  to  such  a  fund,  it 
is  nothing  more  than  a  name. 

The  great  English  steamship  companies,  which  are  pecu- 
liarly subject  to  heavy  losses  through  the  sinking  of  their 
vessels  and  similar  accidents,  have  for  many  years  made  it  a 
practice  to  build  up  surplus  funds  consisting  of  outside  invest- 
ments. These  funds  are  intended  as  a  kind  of  insurance 
against  marine  losses  that  cannot  otherwise  be  insured,  and  j 
also  for  the  purpose  of  "dividend  equalization." 

One  trouble  with  this  policy  is  that  it  necessarily  results  in 
tying  up  a  portion  of  the  capital  of  the  company  in  assets  which 
yield  only  a  small  return.  If  the  surplus  fund  is  to  be  of  any  | 
value  for  the  purpose  intended,  it  can  be  invested  only  in  the  " 
best  grade  of  marketable  securities.  Most  companies  which 
are  prosperous  and  expanding  do  not  feel  that  they  can  afiford 
to  take  cash  away  from  the  business  where  it  would  bring 
profits  of  perhaps  10%,  15%,  20%,  or  more,  in  order  to  put 
it  into  securities  that  will  yield  at  best  4  or  5%.  Another 
objection  is  the  fact  that  even  this  low  yield  does  not  neces- 
sarily guarantee  that  the  company's  capital  put  into  invest- 
ments will  remain  intact.  The  oiificials  of  a  manufacturing 
enterprise  are  not  expected  to  be  investment  specialists. 


SURPLUS 


47J^ 


A  s6mewhat  striking  instance  is  given  in  the  record  of  the 
Boston  Belting  Company,  a  long-established  and  substantial 
New  England  institution,  which  has  for  many  years  kept  up 
an  8%  dividend  on  its  stock.  Some  years  ago  the  company 
received  in  settlement  of  a  suit  which  it  had  brought  against 
the  City  of  Boston,  a  sum  of  approximately  $1,000,000.  In- 
asmuch as  the  cash  was  not  needed  immediately  in  the  business, 
and  as  it  was  not  thought  best  to  distribute  it  to  stockholders, 
it  was  decided  to  invest  it  in  certain  securities,  which  were 
then  considered  high-grade.  These  securities  included  1,000 
shares  each  of  the  stock  of  the  New  Haven  Railroad  and  of 
the  stock  of  the  Boston  and  Albany,  besides  other  shares  and 
bonds.  In  19 14,  as  a  result  of  the  drastic  decline  in  all  securi- 
ties, and  especially  in  those  which  had  been  purchased,  it  was 
necessary  to  charge  off  over  $400,000.  Later  an  additional 
$100,000  was  written  off.  It  is  true,  of  course,  that  the  stock- 
holders, if  they  had  received  the  cash,  might  themselves  have 
made  exactly  the  same  mistake  and  would  today  be  in  no  better 
position  financially.  But  the  feeling  exists,  it  is  understood, 
that  hereafter  it  will  be  better  for  the  company  to  distribute 
whatever  cash  is  not  needed  and  to  remain  strictly  a  manufac- 
turing, rather  than  become  in  part  an  investment,  institution. 

In  general,  American  thought  and  practice  are  not  inclined 
to  favor  the  diversion  of  capital  and  energy  away  from  the 
essential  and  legitimate  business  of  a  company  into  outside 
investments.  It  is  generally  agreed  that  regular  dividends 
combined  with  large — or  at  least  adequate — savings  out  of 
annual  income  should  be  features  of  the  financial  management 
of  most  corporations.  However,  this  belief  is  based  upon  the 
assumption  that  the  surplus  thus  credited  is  needed  for  the 
development  of  the  business  and  should  in  fact  constitute  the 
chief  source  of  new  capital.  Wherever  this  assumption  is 
unjustified,  the  general  opinion  would  probably  favor  distribu- 
tion of  profits  even  though  the  rate  may  be  irregular. 


478 


INTERNAL   FINANCIAL   MANAGEMENT 


Surplus  as  a  Source  of  Capital 

In  this  country  the  accumulation  of  surplus  out  of  earn- 
ings is  conceived  almost  wholly  as  a  source  of  fresh  capital. 
As  such  it  is  to  be  contrasted  with  the  policy  of  paying  out 
all,  or  nearly  all,  the  earnings  in  dividends  and  relying  upon 
fresh  issues  of  securities  in  order  to  obtain  new  capital  when 
needed. 

The  great  advantage  of  securing  capital  through  issues 
of  securities  is  that  it  may  be  more  quickly  obtained  and  thus 
advantage  may  be  taken  of  conditions  which  favor  rapid  devel- 
opment. Assume  that  two  competitive  corporations  start  to 
do  business  at  about  the  same  time  with  the  same  amount  of 
capital,  and  that  one  corporation  depends  solely  upon  its  ac- 
cumulating surplus  for  the  capital  with  which  to  finance  exten- 
sions, while  the  other  corporation  distributes  most  of  its 
earnings  in  dividends  but  is  successful  in  raising  fresh  capital 
by  the  sale  of  securities.  If  both  corporations  are  able  to 
work  side  by  side  in  a  normal  way,  it  is  probable  that  in  the 
long  run  the  first-mentioned  policy  will  prove  sounder  and 
more  profitable  and  that  the  stockholders  in  this  first  corpora- 
tion will  eventually  reap  the  benefits  of  their  self-denial.  But 
possibly  both  corporations  cannot  work  side  by  side.  As 
they  expand,  one  or  the  other  is  certain  to  get  the  mastery, 
to  capture  the  market,  and  to  drive  its  competitor  out  of  busi- 
ness. Under  these  conditions  it  may  well  be  that  the  second 
corporation,  through  its  policy  of  selling  securities,  may  be 
able  to  raise  needed  capital  more  quickly  and  thus  secure  the 
dominating  position  which  is  the  goal  of  both,  before  the  first 
corporation  has  made  a  good  start. 

Somewhat  similar  conditions  frequently  exist.  A  corpora- 
tion formed  to  manufacture  and  sell  a  new  device  may  find  it 
vitally  necessary  to  cover  its  field  before  some  other  device 
can  be  brought  out  and  introduced  as  an  effective  competitor. 
Or  a  company  may  have  in  hand  a  project  which  is  peculiarly 


SURPLUS 


479 


timely,  such  as  accepting  a  new  and  profitable  contract.  In 
all  cases  where  the  element  of  time  in  developing  a  business 
is  a  factor  of  great  importance,  the  advantage,  as  between  the 
two  methods  of  raising  capital,  rests  with  the  method  of  issu- 
ing securities. 

The  great  advantage,  on  the  other  hand,  of  securing  capital 
through  savings  consists  of  the  steadiness  and  soundness  with 
which  the  busmess  may  in  this  way  be  developed.  It  will  not 
suddenly  spurt  ahead — perhaps  before  adequate  preparation 
has  been  made  or  before  an  effective  organization  can  be 
brought  together.  It  will  grow,  year  by  year,  adding  a  new 
piece  of  machinery  here,  erecting  an  addition  to  its  plant 
there,  gradually  increasing  its  organization  until  some  day — 
almost  to  the  surprise  of  its  own  founders — it  finds  itself  a 
leader  among  its  competitors.  Something  like  this,  as  has 
already  been  intimated,  was  the  history  of  the  Carnegie  Steel 
Company — in  fact,  this  has  been  the  history  of  probably  75% 
of  the  great  industries  of  the  country.  The  other  25%,  have 
been  built  up  chiefly  by  the  more  rapid,  more  attractive,  and 
more  dangerous  process  of  bringing  together  great  sums  of 
capital  through  the  issuance  of  securities. 

It  has  been  remarked  above  that  the  effect  of  making  addi- 
tions to  assets  through  the  accumulation  of  savings  is  not  only 
to  increase  earnings,  but  also  to  stabilize  them.  This  is  due 
chiefly  to  the  operation  of  the  general  principle  that  a  large 
volume  of  business  spread  over  a  wide  range  of  territory  is 
less  subject  to  violent  fluctuations  than  is  a  smaller  volume  of 
business. 

Hidden  Surpluses 

The  remarks  in  one  of  the  earlier  sections  of  this  chapter 
as  to  the  various  sources  of  surplus  may  properly  be  taken  to 
indicate  reasons  for  questioning  the  validity  of  the  surplus 
accounts  which  appear  on  the  balance  sheets  of  many  corpora- 


480  INTERNAL   FINANCIAL   MANAGEMENT 

tions.  If  these  alleged  surpluses  are  based  on  revaluation  of 
the  company's  assets  or  are  derived  from  statements  of  earn- 
ings that  have  been  exaggerated  over  a  series  of  years,  it  may 
easily  happen  that  on  searching  analysis  and  examination  they 
will  vanish  into  thin  air.  There  is  plenty  of  reason  for  a 
questioning  attitude  on  the  part  of  purchasers  of  securities 
when  they  are  supplied  with  a  surplus  statement. 

On  the  other  hand,  many  old  and  well-established  corpora- 
tions may  properly  be  said  to  have  "hidden"  or  secret  surpluses. 
The  situation  arises  out  of  the  practice  over  a  series  of  years 
of  understating  net  income;  of  making  larger  provision  than 
is  necessary  for  reserves;  of  writing  down  drastically  the 
book  values  of  assets,  both  tangible  and  intangible.  The  result 
obviously  is  that  the  balance  sheet  shows  an  understatement 
of  the  value  of  the  company's  assets ;  and  this  understatement 
constitutes  a  hidden  surplus.  If  the  balance  sheet  were  revised 
so  as  to  show  the  true  values  of  the  com_pany's  assets,  the 
surplus  account  would  be  correspondingly  increased. 

In  theory,  the  practice  of  understating  the  values  of 
assets  and  carrying  hidden  surpluses  is  just  as  objectionable 
as  the  practice  of  overstating  values.  The  real  aim  of  the 
accountant  and  of  the  financial  manager  should  be  to  see  to 
it  that  the  balance  sheet  tells  the  exact  truth — neither  more 
nor  less — so  that  every  creditor,  every  prospective  purchaser 
of  securities,  may  take  action  with  his  eyes  open.  However, 
this  idea  is  not  attainable  and,  since  there  must  be  an  error 
on  one  side  or  the  other,  it  is  better  to  err  on  the  side  of  under- 
statement and  overconservatism.  Bankers  and  careful  in- 
vestors place  a  high  value  on  a  balance  sheet  that  gives  evi- 
dence of  having  been  prepared  with  extreme  caution  or  even 
pessimism. 

Banking  houses — and  sometimes  other  firms  as  well — find 
it  useful  to  carry  certain  surpluses  in  the  form  of  underval- 
uations of  securities  and  other  assets  in  order  to  take  care  of 


SURPLUS  481 

exceptional  losses  v/ithout  disturbing  the  appearance  of  the 
balance  sheet.  If  a  bank  suffers  a  serious  defalcation,  for 
example,  it  may  be  highly  injurious  to  its  credit  to  charge 
the  whole  amount  directly  against  surplus,  thus  advertising 
to  its  customers  and  the  world  at  large  that  it  has  met  with 
a  set-back.  In  case  the  bank  has  been  carrying  assets  at  an 
undervaluation,  it  may  resort  in  such  a  case  to  a  revaluation 
of  these  assets  so  as  to  increase  them  by  approximately  the 
same  amount  as  the  loss  that  is  to  be  written  off.  When 
the  next  balance  sheet  appears  it  shows  no  difference  except 
that  the  skilled  analyst  might  be  able  to  detect  changes  iri 
the  valuations  of  assets;  but  this  is  not  usually  possible. 

Hidden  surpluses  have  been  known  to  exist,  not  because 
of  an  especial  degree  of  conservatism  on  the  part  of  directors, 
but  because  it  is  deliberately  intended  to  deceive  sharehold- 
ers as  to  the  real  value  of  their  property.  The  shareholder 
is  induced  to  sell,  when  his  shares  are  desired  by  those  on 
the  inside,  at  a  bargain  price.  Usually  the  next  steps  are 
to  show  the  full  amount  of  the  earnings  and  surplus — with 
perhaps  some  inflation — to  recapitalize  and  to  sell  the  new 
issues  at  a  heavy  profit. 

This  is  a  subject  which  will  again  be  referred  to  in  the 
chapters  which  discuss  methods  of  exploitation. 


CHAPTER    XXI 

BUDGETS 

Nature  and  Types  of  Budgets 

In  handling  governmental  business  in  nearly  all  civilized 
countries,  it  is  customary  for  the  executive  power  to  submit 
to  the  legislative  power  a  detailed  estimate  of  the  prospective 
revenue  and  outgo  for  the  succeeding  fiscal  year.  This  esti- 
mate is  known  as  a  budget.  It  may  be  described  as  a  detailed 
income  and  expenditure  statement  made  out  in  advance  of  the 
period  which  it  covers;  it  is  a  prediction  or  a  guide,  not  a 
record  of  results.  In  governmental  practice  it  is  customary 
to  secure  the  approval  of  the  legislative  power  after  required 
revisions  have  been  made ;  and  thereupon  the  adopted  budget 
in  its  final  form  becomes  a  binding  appropriation  of  the 
expected  revenue.  The  various  departments  of  the  govern- 
ment are  not  authorized  to  go  beyond  the  sums  appropriated 
to  their  departments  in  their  expenditures  for  the  fiscal  year. 

In  private  corporations  the  budget,  except  in  rough  and 
fragmentary  form,  has  not  been  much  used.  There  is  a  grow- 
ing interest,  however,  in  the  application  of  the  principle  of 
the  budget  in  some  practical  form  with  a  view  to  forestall- 
ing the  serious  financial  errors  and  miscalculations  that  so  fre- 
quently wreck  the  careers  of  otherwise  successful  corpora- 
tions. Many  directors  and  treasurers  of  corporations  con- 
sider the  present  practice  entirely  too  loose  and  too  near- 
sighted and  are  looking  to  the  budget  as  a  means  of  better- 
ing these  conditions.  It  should  be  possible  to  make  detailed 
financial  plans  and  schedules  for  a  year  or  more  ahead,  just 
as  it  is  possible  for  many  companies  to  make  detailed  operat- 
ing plans  and  schedules. 

482 


BUDGETS 


483 


Budgets  are  divisible  into  two  classes — those  which  are 
merely  estimates  for  the  benefit  of  the  active  financial  mana- 
gers and  those  which  are  adopted  as  binding  appropriations. 
It  is  usually  best  to  start  by  making  budgets  of  the  first 
class — unless  there  is  some  emergency  which  demands  that 
a  definite  financial  plan  be  adopted  and  adhered  to — always 
having  in  mind  the  expectation  that  the  budget  will  in  time 
reach  the  stage  of  being  either  formally  adopted  or  accepted 
by  general  agreement  as  stating  the  limit  for  the  year's  expen- 
ditures. 

Objections  to  the  Use  of  Budgets 

A  constantly  recurring  objection,  not  only  to  formal  bud- 
gets, but  to  all  attempts  to  make  advance  estimates,  is  that  the 
volume  of  sales  of  most  corporations  is  not  under  control, 
nor  can  it  be  foreseen.  There  is  undoubtedly  much  truth  in 
this  assertion.  Yet  in  the  great  majority  of  cases  this  difificulty 
is  exaggerated.  As  a  matter  of  fact,  the  manufacturer  or 
trader  should  be  able,  within  reasonable  limits,  to  exercise  a 
fairly  close  control  over  the  volume  of  his  sales;  if  not,  his 
business  is  clearly  on  an  extremely  unsound  basis.  His  past 
experience  should  give  him  a  reasonably  clear  idea  of  the 
normal  percentage  of  costs  to  volume  of  business  in  his  line. 
And,  while  the  mere  process  of  increasing  selling  expenditures 
will  not  in  itself  increase  the  volume  of  business,  the  pro- 
prietor should  be  able,  with  reasonable  regard  to  conditions, 
to  estimate  with  fair  certainty  the  selling  expenditures  that 
will  increase  his  business  to  a  predetermined  volume. 

It  is  also  true  that  in  many  lines  of  business  extreme  fluc- 
tuations take  place  from  time  to  time.  Manufacturers  of  rail- 
way supplies,  for.  example,  are  able  to  sell  more  of  their  product 
when  the  railroads  are  prosperous,  but  no  extra  selling  effort 
will  maintain  their  sales  when  the  railroads  are  not  making 
money  and  cease  to  buy. 


484  INTERNAL   FINANCIAL   MANAGEMENT 

It  IS  the  business  of  the  budget-maker  to  form  a  careful 
estimate 'of  the  probable  results  of  increased  selling  expendi- 
tures, giving  due  weight  to  all  factors  both  favorable  and 
unfavorable.  His  ability  as  a  financial  man  w^ill  be  tested  by 
the  degree  of  accuracy  v^ith  which  he  can  foretell  the  probable 
business  conditions  of  the  coming  year. 

In  estimating  the  coming  volume  of  business,  three  fac- 
tors should  be  considered :  ( i )  estimated  expenditures  during 
the  coming  year  directed  toward  building  up  sales ;  (2)  normal 
proportion  of  sales  expense  to  volume  of  sales;  and  (3)  prob- 
able effect  of  general  business  and  financial  conditions  on  the 
particular  line  of  business. 

The  uncertainty  as  to  the  result  of  the  selling  effort  is  the 
crucial  difficulty  to  be  overcome.  Once  the  anticipated  volume 
of  business  is  calculated,  it  is  comparatively  simple  to  deter- 
mine the  expenditures  necessary  for  the  proper  handling  of 
this  estimated  volume. 

Another  related  objection  to  budget-making  is  to  the 
effect  that  the  business  will  fluctuate  widely  with  business 
conditions  and  will  not  run  in  a  uniform  channel.  This  objec- 
tion simply  tends  to  show,  first,  that  the  budget  should  be 
made  on  a  monthly  rather  than  on  a  yearly  basis  with  a  view 
to  increasing  its  accuracy  and,  in  the  second  place,  that  a 
margin  should  be  allowed  for  inaccuracies  and  fluctuations. 

A  third  objection  to  all  budgets  is  the  alleged  danger  of 
introducing  red  tape  and  hampering  the  free  judgment  and 
action  of  operating  officials,  which  is  essential  to  an  energetic 
and  growing  enterprise.  The  obvious  answer  to  this  objection 
is  that  the  free  and  untrammelled  action  of  sales  managers, 
buyers,  superintendents  of  factories,  and  other  operating  of- 
ficials, has  been  probably  the  most  prevalent  cause  of  financial 
embarrassments. 

As  a  matter  of  fact,  a  definite  and  binding  budget,  which 
can  be  debated  and  settled  by  all  the  responsible  officials  and 


BUDGETS 


4B5 


the  directors  of  a  company  at  the  beginning-  of  a  fiscal  year, 
is  a  highly  effective  method  of  securing  the  unitedness  of 
purpose  which  is  an  essential  factor  in  every  efficient  organi- 
zation. 

Necessity  for  Continual  Revision 

The  objections  above  cited  are  all  based  on  the  assumption 
that  a  budget  once  adopted  is  an  absolutely  inflexible  and  un- 
changeable strait- jacket  from  which  no  relief  can  be  obtained 
until  after  the  expiration  of  the  fiscal  year  in  which  it  holds 
good.  If  this  were  actually  the  state  of  affairs,  the  objections 
would  have  weight.  But  the  efficient  budget,  as  used  by  some 
corporations,  is  subject  to  continual  revision. 

First  of  all,  it  is  made  both  on  a  yearly  basis  and  on  a 
monthly  basis.  The  yearly  budget  enters  into  few  details, 
but  gives  a  comprehensive  view  of  the  anticipated  income  from 
various  sources — the  anticipated  expenditures,  together  with 
the  approximate  result  of  the  whole  year's  business. 

Supplementing  the  yearly  budget  and  controlled  by  it,  are 
the  monthly  budgets,  which  enter  into  as  much  detail  as  may 
be  required  by  the  nature  of  the  business,  and  make  due  allow- 
ances, so  far  as  they  can  be  foreseen,  for  the  seasonal  and 
month-by-month  fluctuations  which  occur  in  every  business. 
The  month-by-month  budget  may  be  checked  up  at  the  end 
of  each  month  against  the  actual  results  of  that  month;  the 
causes  of  discrepancies  may  be  noted;  new  contracts  or  pros- 
pects for  enlarging  or  reducing  business  during  the  months 
immediately  following,  may  be  taken  into  consideration.  With 
all  these  and  other  similar  factors  in  full  view,  such  revisions 
as  are  at  the  time  required  may  readily  be  agreed  upon. 

Income  Basis  vs.  Cash  Basis 

A  practical  question  that  must  be  answered  before  the 
budget  can  be  prepared  is  whether  it  should  be  based  upon 


486  INTERNAL  FINANCIAL  MANAGEMENT 

income  and  expenditures  or  upon  cash  receipts  and  cash  dis- 
bursements. Income  and  expenditure  constitute  the  correct 
measure  of  profits  and  therefore  should  be  used  whenever  the 
prime  purpose  of  the  budget  is  to  control  expenditure  and  to 
insure  a  satisfactory  showing  of  profits  during  the  ensuing 
year.  Cash  receipts  and  cash  disbursements,  on  the  other 
hand,  measure  the  financial  status  and  financial  prospects  of 
the  business  and  should  be  used  whenever  the  prime  purpose 
is  to  make  sure  that  the  business  will  run  on  a  basis  that  is 
financially  sound. 

The  truth  is  that  all  successful  plans  for  business  should 
contemplate  both  prospective  income  and  expenditure  and 
prospective  receipts  and  disbursements,  and  that  emphasis  as 
to  which  of  the  two  is  more  important  depends  to  a  consider- 
able extent  upon  the  business.  In  all  cases  except  those  in 
which  income  and  expenditure  and  receipts  and  disburse- 
ments are  practically  identical,  there  should  be  two  separate 
budgets.  The  income  and  expenditure  budget  should  be  for 
the  guidance  of  all  the  operating  officials  of  the  company;  it 
should  show  in  some  detail  the  amounts  that  may  be  expended 
and  the  results  that  are  expected  in  each  department.  This  is 
the  budget  that  serves  the  purpose  of  facilitating  control. 

The  receipts  and  disbursements  budget  may  be  only  for 
the  private  information  and  guidance  of  the  treasurer,  or  of 
those  who  are  responsible  for  the  financial  management  of  the 
company.  It  will  indicate  just  where  the  actual  cash  receipts 
of  each  month  are  to  come  from  and  through  what  channels 
the  cash  is  to  flow  out. 

The  budget  of  cash  receipts  and  expenditures  may  itself 
be  divided  into  two  parts,  the  first  part  including  only  those 
transactions  which  have  to  do  with  current  operations,  and 
the  second  part  including  only  capital  transactions.  By  com- 
bining the  two  parts  the  financial  management  may  look  ahead 
and  make  certain  that  ample  bank  balances  will  be  maintained ; 


BUDGETS 


487 


calculate  to  what  extent  they  will  be  dependent  upon  bank 
and  other  loans ;  determine  exactly  how  far  they  should  go  in 
taking  advantage  of  cash  discounts;  and  otherwise  guide  the 
financial  course  of  the  company  with  skill  and  accuracy. 

Income  Budgets 

Taking  up  now  in  more  detail  the  procedure  in  forming 
a  budget,  first  on  the  income  and  expenditure  basis,  and 
second  on  the  receipts  and  disbursements  basis,  we  have  to 
consider  the  extent  of  the  income  for  the  period  (whether  it 
be  monthly,  half-yearly,  or  yearly)  which  may  fairly  be  re- 
garded as  assured.  Manufacturing  companies  are  likely  to 
have  certain  regular  customers  on  whom  they  may  safely 
count,  unless  extraordinary  conditions  prevail,  for  a  given 
amount  of  business.  The  same  thing  is  true  of  wholesale 
trading  companies.  The  companies,  both  manufacturing  and 
trading,  which  are  selling  at  retail,  can  at  least  work  out  from 
their  own  records  the  minimum  limits  of  their  sales.  The 
same  thing  may  be  done  by  public  service  and  transportation 
companies.  Companies  which  operate  on  long-term  contracts 
extending  over  two  or  three  years  or  more  may  conceivably  be 
in  the  position  of  having  all  their  capacity  occupied  with  con- 
tracts previously  arranged,  in  which  case  all  their  income  will 
be  assured. 

Most  companies  have  in  addition  certain  possibilities  which 
require  careful  study  and  good  judgment  in  order  to  make 
possible  a  reasonably  accurate  estimate  of  earnings  which  are 
not  assured  but  are  probable.  In  making  up  these  estimates, 
the  financial  manager  will  naturally  be  guided  to  a  great  extent 
by  the  views  of  the  sales  manager  and  other  operating  officials 
who  are  probably  in  closer  touch  than  he  is  with  the  company's 
sources  of  income.  It  is  well  to  state  separately  the  amount 
of  gross  earnings  which  may  be  regarded  as  probable  but  is 
not  assured. 


488  INTERNAL   FINANCIAL   MANAGEMENT 

The  classification  of  expenses  should  follow  the  same  lines 
of  division.  It  is  well  to  estimate,  first  of  all,  what  may  be 
called  the  fixed  and  necessary  expenses  of  the  business,  assum- 
ing usually  that  it  is  intended  to  hold  intact  the  organization 
that  has  been  built  up.  These  necessary  expenses  will  include, 
therefore,  the  salaries  of  officers  and  their  assistants,  of  sales- 
men, clerks,  and  working  men,  the  purchases  of  raw  mate- 
rials necessary  for  production  up  to  the  amount  that  is  assured, 
the  up-keep  of  the  plant,  and  other  necessary  expenses. 

A  second  section  will  show  the  increase  in  expenses  neces- 
sary in  case  the  probable  volume  of  business,  as  previously 
estimated,  is  secured.  A  third  section  will  show  further  in- 
creases necessary  in  case  the  possible  volume  of  business  is 
attained. 

Cash  Budgets 

The  receipts  and  disbursements  budget  may  be  arranged 
in  three  divisions  to  correspond;  or  it  may  be  necessary  to 
base  it  wholly  upon  the  estimate  of  possible  earnings.  In 
those  lines  of  business,  however,  in  which  sales  are  made  on 
a  long-term  or  instalment  basis,  it  will  be  found  of  the  highest 
importance  to  make  the  receipts  and  disbursements  budget  in 
considerable  detail  and  with  a  view  to  all  possible  contingen- 
cies. Not  to  do  so  is  to  invite  serious  trouble,  for  an  enlarged 
volume  of  business  in  such  industries  necessarily  means  a 
proportionate  or  more  than  proportionate  tying  up  of  cash 
resources.  A  budget  may  even  indicate  that  for  this  reason 
it  is  unwise  to  attempt  to  handle  the  volume  of  business  which 
the  sales  manager  and  operating  officials  would  like  to  secure. 
The  making  of  a  receipts  and  disbursements  budget  may  be 
sufficient  in  itself  to  reveal  the  breakers  ahead  and  to  inspire 
caution. 


CHAPTER    XXII 

FINANCIAL    STANDARDS 

Need  for  Standards 

A  man  who  keeps  all  his  property  in  the  form  of  cash  and 
government  bonds  has  comparatively  little  to  worry  or  think 
about;  but,  on  the  other  hand,  he  is  not  using  his  resources 
productively.  As  the  same  man  proceeds  with  the  development 
of  some  business  enterprise,  he  puts  more  and  more  of  his 
capital  into  the  various  forms  of  tangible  and  intangible  assets 
which  are  required  for  the  upbuilding  of  the  business. 
Presently,  if  he  is  not  careful,  he  may  find  himself  short  of 
cash  and  unable  to  meet  his  obligations,  although  he  may  be 
earning  good  profits. 

The  same  tendency  is  present  everywhere.  The  executives 
who  are  managing  the  financial  affairs  of  a  company  cannot 
assist  in  making  the  business  profitable  merely  by  piling  up 
unnecessary  cash  resources.  They  must  be  prepared  to  venture 
out  into  the  main  current  of  business  affairs  along  with  their 
associates.  And  as  they  venture  farther  and  farther,  the  danger 
increases  that  their  financial  craft  may  be  swept  out  of  their 
control.  It  requires  constant  watchfulness  and  sound  knowl- 
edge to  steer  a  middle  course  between  excessive  caution  on  the 
one  side,  and  rashness  in  financial  management  on  the  other. 

It  would  be  far  easier  to  keep  to  this  middle  course  if  the 
safe  channels  were  more  clearly  marked  out.  A  manufac- 
turer, for  example,  takes  on  an  enlarged  volume  of  business 
with  the  result  that  his  working  capital  is  much  reduced;  he 
finds  it  difficult  to  determine  with  any  accuracy  whether  this 
reduction  is  approaching  the  danger  point  or  not;  he  has  no 
definite  rule  or  standard  by  which  to  guide  his  course. 

489 


490 


INTERNAL   FINANCIAL   MANAGEMENT 


Many  such  standards  of  operating  and  financial  practice 
are  established  for  particular  industries  by  general  consent. 
These  standards  are  in  many  cases  probably  incorrect,  but  they 
serve  to  assist  those  who  are  forming  and  testing  policies. 
For  example,  the  percentage  of  cost  of  carrying  on  various 
lines  of  retail  business,  in  comparison  with  the  gross  sales  of 
the  business,  has  been  studied.  It  is  generally  said  that  the  cost 
of  conducting  a  retail  book  store  is  about  28%  of  the  gross 
sales.  Again,  in  many  lines  of  manufacturing  the  percen- 
tages of  prime  cost,  of  overhead,  and  of  selling  cost,  to  the 
prices  of  the  articles  manufactured,  are  quite  definitely  agreed 
upon. 

As  yet  no  general  standards  of  financial  practice  have 
been  worked  out  in  any  detail  or  with  any  approach  to  ac- 
curacy. At  this  stage,  it  is  not  possible  for  any  individual  to 
collect  and  collate  all  the  data  that  would  be  necessary  to  make 
a  complete  line  of  standards  of  financial  practice.  This  work 
should  be  done  by  such  associations  as  the  American  Institute 
of  Accountants,  the  American  Bankers'  Association,  the  In- 
vestment Bankers'  Association,  and  the  United  States  Chamber 
of  Commerce.  If  such  a  work  were  done  the  result  would  be 
of  the  highest  value  to  business  managers. 

Relation  of  Working  Capital  to  Total  Capital 

Following  are  the  percentages  of  working  capital  to  total 
capital  as  shown  in  recently  published  balance  sheets  of  a  con- 
siderable number  of  prominent  American  industrial  corpora- 
tions, which  have  been  selected  practically  at  random.  For 
convenience,  these  companies  are  divided,  for  the  present 
purpose,  into  three  groups:  those  having  a  proportion  of 
working  capital  below  15%  of  total  capital  being  placed  in 
the  first  group;  those  having  between  15  and  35%  in  the 
second  group  and  those  having  above  35%  In  the  third 
group. 


FINANCIAL   STANDARDS  401 

Percentage  of  Working  Capital  to  Total  Capital 

I 

Mexican  Petroleum  Company 3-5% 

California  Petroleum  Company   3-9% 

Pittsburg  Coal  Company 8.9% 

United  Fruit  Company    9    % 

Railway  Steel  Spring  Company  13    % 

II 

Sears-Roebuck  Company   I5«i% 

United  States  Steel  Corporation   16.2% 

Pressed  Steel  Car  Company 18.3% 

General  Chemical  Company   19    % 

New  York  Air  Brake  Company 21    % 

National  Lead  Company   24    % 

Lackawanna  Steel  Company  24.4% 

Baldwin  Locomotive  Company  28.1%  . 

Cambria  Steel  Company    33-5% 

III 

Crex  Carpet  Company  36.8% 

Armour  and  Company    37    % 

American  Woolen  Company 374% 

American  Sugar  Refining  Company  39-6% 

American  Tobacco  Company 42.8% 

Underwood  Typewriter  Company 43-2% 

Central  Leather  Company  48.6% 

Swift  and  Company   51    % 

Rumely  Company  52.6% 

Morris  and  Company  53    % 

Deere  and  Company   70    % 

International  Harvester  Company  81.3% 

It  is  interesting  to  observe  that,  v^ith  one  or  tv^o  striking- 
exceptions,  companies  which  are  competitive  or  which  do  the 
same  general  class  of  business  have  approximately  the  same 
relations  of  working  to  total  capital.  Note,  for  example,  the 
close  correspondence  between  the  California  Petroleum  Com- 


492 


INTERNAL   FINANCIAL   MANAGEMENT 


pany  and  the  Mexican  Petroleum  Company.  The  only  other 
company  in  the  list  which  is  engaged  in  the  extraction  of  raw 
materials  is  the  Pittsburg  Coal  Company,  which  also  has  a 
low  percentage.  Extractive  companies  have  little  need  for 
large  inventories,  stocks  of  raw  material,  or  other  working  as- 
sets, except  cash  and  accounts  receivable.  And  their  accounts 
receivable  do  not  run  for  long  periods.  The  United  Fruit 
Company  is,  to  a  large  extent,  engaged  in  transportation 
rather  than  in  producing  and  selling.  As  has  been  previously 
pointed  out,  transportation  operations  do  not  call  for  large 
amounts  of  working  capital. 

The  various  railway  equipment  companies,  including  the 
Railway  Steel  Spring  Company  in  Group  I  and  the  Baldwin 
Locomotive  Company,  the  New  York  Air  Brake  Company, 
and  the  Pressed  Steel  Car  Company  appearing  in  Group  II, 
all  have  a  low  proportion  of  working  capital  compared  with 
other  industrial  companies.  It  may  be  assumed  that  in  railway 
equipment  manufacturmg,  comparatively  little  money  is  tied 
up  in  accounts  receivable.  The  railroad  companies  pay  usually 
in  the  form  of  notes  which  are  readily  discountable,  thus 
making  unnecessary,  for  reasons  that  have  previously  been 
discussed,  a  large  excess  of  current  assets  over  current  lia- 
bilities. 

All  the  steel  manufacturing  companies,  including  the 
Cambria  Steel  Company,  the  Lackawanna  Steel  Company,  and 
the  United  States  Steel,  are  included  in  the  second  division, 
and  all  except  the  Cambria  Steel  Company  have  working 
capital  proportions  below  the  average. 

In  Group  III  are  included  a  number  of  important  companies 
which  may  be  subdivided  into  two  classes :  those  which  find  it 
necessary  to  carry  large  inventories  or  materials,  goods  in 
process,  and  finished  goods,  and  those  which  find  it  necessary 
to  sell  on  an  instalment  or  long-term  basis,  so  that  accounts 
receivable  are  always  heavy.     The  first-mentioned  class  in- 


FINANCIAL   STANDARDS  40^ 

eludes  American  Sugar  Refining  Company,  American  Tobacco 
Company,  American  Woolen  Company,  Central  Leather  Com- 
pany, and  Crex  Carpet  Company. 

The  three  agricultural  implement  companies  in  this  group, 
International  Harvester  Company,  Rumely  Company,  and 
Deere  and  Company,  as  well  as  the  Underwood  Typewriter 
Company,  belong  in  the  class  which  sell  their  products  on  long 
terms. 

The  meat-packing  companies — Morris,  Swift,  and  Armour 
— find  it  necessary  to  carry  large  inventories  of  live  stock 
and  of  goods  in  process. 

On  the  whole,  in  running  over  the  list  that  has  just  been 
given  and  in  examining  large  numbers  of  other  industrial 
balance  sheets,  it  becomes  fairly  evident  that  well-managed 
business  enterprises  customarily  follow  standards  that  are 
more  or  less  similar  and  that  lead  them  to  establish  similar 
proportions  of  working  to  total  capital.  The  exceptional  cases, 
both  above  and  below  the  normal  proportions,  are  for  the  most 
part  readily  explainable. 

Cash  and  Cash  Resources 

Closely  related  standards  and  tests  apply  to  the  propor- 
tions of  cash  and  resources  immediately  convertible  into  cash 
(principally  securities  held  for  sale)  to  total  capital,  to  gross 
volume  of  business,  and  to  current  liabilities. 

Inasmuch  as  banks  are  devoted  almost  exclusively  to 
handling  cash  and  credit,  we  should  naturally  expect  that 
their  practice  in  respect  to  these  factors  would  be  more  defi- 
nitely standardized  than  the  practice  of  mercantile  manufac- 
turing companies,  and  this  is  actually  the  case.  The  experience 
of  financiers  over  many  generations  has  gradually  crystallized 
into  the  conclusion  that  in  an  ordinary  commercial  bank,  which 
is  effectively  using  most  of  its  capital  in  its  own  business,  that 
capital  ought  to  be  invested  chiefly  or  wholly  in  cash  or  at 


494  INTERNAL  FINANCIAL  MANAGEMENT 

least  in  cash  and  secondary  reserves  immediately  convertible 
into  cash.  The  proportion  of  cash  to  demand  liabilities  has 
been  fixed  by  long  experience  at  from  15  to  25%. 

The  practice  of  industrial  concerns  in  handling  cash  is, 
of  course,  on  an  entirely  different  basis  and  is  not  so  readily 
standardized.  The  proportion  of  cash  to  total  capital  varies 
from  as  low  as  1%  to  as  high  as  16%,  which  has  been  at- 
tained by  the  General  Electric  Company.  It  very  seldom, 
however,  runs  higher  than  7  or  8%,  which  is  considerably 
above  the  average. 

The  remarkable  discrepancy  between  the  practice  in  this 
respect  in  the  United  States  and  Canada  should  be  noted.  In 
the  last-named  country  the  relations  between  banks. and  indus- 
trial enterprises  are  much  closer  than  is  customary  in  the 
United  States.  The  Canadian  companies  depend  much  more 
largely  upon  bank  borrowings  to  restore  their  cash  balances 
whenever  they  become  depleted.  Nor  do  the  banks  impose 
the  requirement,  which  is  customary  in  this  country,  that 
bank  balances  should  average  at  least  20  to  25%  of  bank 
loans. 

The  Canadian  practice  as  outlined  above  is  in  accord  with 
the  practice  in  most  European  countries,  particularly  in  Ger- 
many, and  with  the  practice  of  European  corporations  operat- 
ing in  South  America  and  other  foreign  countries.  Canadian 
practice  emphasizes  the  suggestion  that  the  proportions  of  cash 
and  cash  resources  to  capital,  sales,  and  liabilities,  depend 
largely  upon  the  nature  of  the  company's  banking  connections. 
Or,  to  repeat  the  phrase  used  in  a  preceding  chapter,  the  re- 
quired amount  of  cash  depends  upon  the  ''convertibility  into 
cash  of  other  working  assets." 

In  most  American  industrial  companies,  the  proportion  of 
average  cash  to  gross  sales  is  about  3  to  6%.  If  the  company 
is  paying  its  bills  promptly  and  is  not  overborrowing,  current 
liabilities  should  not  exceed  20  to  30%  of  annual  sales.    This 


I 


FINANCIAL   STANDARDS 


495 


refers,  of  course,  to  the  business  of  manufacturing  a  standard 
article  or  articles  which  can  be  sold  in  fairly  steady  volume. 
On  the  basis  of  these  figures,  cash  and  cash  resources  should 
be  about  12  to  25%  of  current  liabilities,  and  this  is  not  far 
from  the  customary  showing. 

Turnover 

The  definition  of  the  term  and  the  reasons  for  laying 
great  importance  upon  quick  turnover  have  previously  been 
discussed.  The  additional  point  that  belongs  in  this  chapter  is 
a  statement  as  to  the  ratio  of  turnover  which  may  be  accepted 
as  standard  in  various  lines  of  business.  This  statement  is  by 
no  means  complete  or  conclusive,  but  is  based  upon  the  frag- 
mentary information  which  it  is  now  possible  to  obtain  from 
the  records  of  business  firms. 

A  cotton  goods  commission  house  which  does  a  little  financ- 
ing of  sales,  employs  some  traveling  salesmen,  and  carries  no 
stock,  has  total  working  assets  of  $400,000.  The  annual 
sales  of  this  house  are  about  $3,500,000,  showing  a  turnover 
of  nearly  900%.  This  is  regarded  as  a  good,  though  not  ab- 
normal, showing. 

A  large  department  store  is  said  to  carry  an  average  stock 
of  $8,000,000  to  $10,000,000,  and  to  have  average  sales  of 
$15,000,000  to  $20,000,000,  showing  a  turnover  of  200%. 

It  is  said,  on  excellent  authority,  that  many  retail  grocers 
make  a  complete  turnover  at  least  once  a  month,  equivalent 
to  1,200%  for  the  year,  while  country  stores,  which  are  forced 
to  carry  a  large  assortment  of  stock,  are  well  satisfied  to  do 
300  to  400%.  One  small  retail  store  is  recently  reported  to 
have  done  900%,  but  this  is  an  extraordinary  showing. 

Operating  Ratios 

One  of  the  most  important  standards  or  tests  of  ef^ciency 
in  all  lines  of  business  is  the  percentage  of  total  expense  of 


496 


INTERNAL   FINANCIAL   MANAGEMENT 


running  the  business,  including  manufacturing,  selling,  and 
administration,  to  the  gross  sales — more  commonly  known 
as  the  "operating  ratio."  It  is  clear  that  the  difference  between 
ioo%  which  represents  gross  sales  and  the  operating  ratio  is 
the  percentage  of  gross  profit  on  sales.  The  lower  this  per- 
centage of  gross  profit — or,  in  other  words,  the  higher  the 
operating  ratio — the  more  unstable,  other  things  being  equal, 
is  the  business  as  a  money  maker;  for  a  high  operating  ratio 
means  that  even  a  slight  variation  in  expenses  may  be  suffix 
cient  to  transform  a  profit  into  a  loss.  On  the  other  hand, 
a  phenomenally  low  operating  ratio  indicates  a  business  which 
is  earning  excessive  profits  and  is  therefore  peculiarly  subject 
to  competitive  attack. 

The  term  was  first  applied,  and  is  still  most  generally  used, 
in  connection  with  steam  railroads.  The  ratio  here  is  low, 
usually  not  more  than  70% ;  sometimes  it  climbs  to  80%  and 
90%,  and  sometimes  falls  as  low  as  55%.  This  low  ratio 
is  offset  by  high  fixed  charges.  In  1906  the  ratio  of  the 
Chicago,  Rock  Island  and  Pacific  Railway  went  up  to  89%, 
and  in  1907  to  87%.  The  ratio  for  electric  railways  decreased 
from  an  average  of  60.1%  in  1907,  to  58.7%  in  19 12.  The 
lowest  figure  was  57.5%  in  1902.  However,  the  operating 
expenses  for  19 12  included  over  $7,000,000  charged  for  de- 
preciation, compared  with  no  similar  charge  for  the  earlier 
years.  Some  recent  ratios  of  industrial  companies  are  the 
following : 

Westinghouse  Air   Brake   Company    61% 

American  Piano  Company   64% 

Sears-Roebuck  Company  89% 

American  Steel  Foundry  Company 90% 

F.  W.  Woolworth  Company  91  % 

Wells-Fargo  Express  Company    93% 

American  Express  Company   94% 

Kresge  Company    94% 

Adams  Express  Company  97% 


FINANCIAL   STANDARDS  497 

Companies  which  manufacture  specialties  that  enjoy  a 
ready  market  and  are  protected  by  patents  or  otherwise  from 
effective  competition,  may  properly  have  a  Hght  operating 
ratio  and  an  unusually  large  percentage  of  profit  on  sales. 
This  is  presumably  the  case  with  the  Westinghouse  Air  Brake 
Company  and  perhaps  with  the  American  Piano  Company. 
Normally,  a  manufacturing  concern  will  have  a  ratio  not  far 
from  90%,  as  shown  in  the  above  list  by  the  American  Steel 
Foundry  Company.  Trading  companies,  such  as  Sears-Roe- 
buck, the  Kresge  Company,  and  the  F.  W.  Woolworth  Com- 
pany, run  as  high  or  even  a  little  higher.  The  three  express 
companies,  and  particularly  the  Adams  Express,  are  running 
on  a  dangerously  close  margin,  due  to  the  persistent  rise  in 
expenses  and  reduction  in  revenue  during  recent  years.  For- 
merly a  ratio  of  87  to  93%  was  about  normal. 

Stock  and  Bond  Issues  in  Relation  to  Gross  Earnings 

Assuming  that  the  operating  ratio  of  a  company  is  not  far 
from  normal  in  its  line,  a  fairly  definite  relation  may  be  some- 
times established  between  gross  earnings  and  stock  and  bond 
issues.  In  the  chapter  on  capitalization  (Chapter  VIII)  it 
has  been  suggested  that  industrial  companies  frequently  show 
a  total  capitalization  approximately  equal  to  their  gross  earn- 
ings. This  relation  may  easily  exist  wherever  the  percentage 
of  profit  on  sales  is  about  equivalent  to  the  percentage  of  profit 
expected  on  capital  invested  in  that  industry.  Inasmuch  as 
companies  which  carry  on  a  business  that  involves  considerable 
fluctuations  and  risks  expect  a  high  percentage  of  profit  lx)th 
on  sales  and  on  capital  invested,  it  is  clear  that  the  correspon- 
dence between  gross  earnings  and  capitalization  is  not  purely 
accidental. 

Wherever  the  operating  ratio,  however,  leaves  a  margin 
of  profit  on  sales  that  is  either  much  higher  or  much  lower 
than  the  expected  rate  on  invested  capital,  this  relation  of 


498 


INTERNAL   FINANCIAL   MANAGEMENT 


equality  between  gross  earnings  and  capitalization  will  not 
exist,  but  will  be  supplanted  by  some  other  fairly  stable  ratio. 
Companies  which  do  a  large  business  on  a  small  margin — 
commission  houses,  retail  stores,  manufacturers  of  staples, 
and  the  like — will  customarily  have  a  capitalization  much 
smaller  than  gross  sales.  Companies  like  railroads,  interurban 
lines,  and  public  utilities,  which  have  a  low  operating  ratio, 
will  customarily  have  a  capitalization  of  several  times  their 
gross  earnings.  Electric  street  railway  companies  normally 
have  a  capitalization  of  four  to  six  times  gross  earnings. 
A  little  figuring  based  on  the  normal  operating  ratio  and 
the  normal  relations  of  gross  earnings  to  capitalization  in  any 
given  line  of  industry,  will  often  prove  an  exceedingly  helpful 
method  of  testing  in  a  rough  way  the  capitalization  that  will 
be  proper  for  a  given  enterprise. 

Analysis  Based  on  Financial  Standards 

Bankers,  credit  men,  investors,  and  others  who  are  not 
intimately  acquainted  with  a  given  business,  are  frequently 
called  upon  to  form  tentative  judgments  as  to  the  financial 
ef^ciency  of  a  business,  based  chiefly  upon  statements  of  ac- 
count that  are  furnished  to  them,  or  even  upon  a  few  uncon- 
nected figures.  The  process  of  piecing  together  these 
fragments  and  from  them  forming  a  fairly  definite  mental 
picture  of  the  status  and  efficiency  of  the  concern,  is  not  unlike 
the  work  of  those  scientists  who  from  a  few  small  bones  are 
able  to  reconstruct  the  skeleton  of  some  prehistoric  animal.  In 
making  an  analysis  and  "reconstruction"  of  this  kind  it  is 
helpful  to  be  guided  by  whatever  financial  standards  are  avail- 
able which  apply  to  the  business  under  consideration. 


Part  V — Financial  Abuses  and  Involvements 


CHAPTER    XXIII 

EXPLOITATION    BY    OFFICERS 

Exploitation  Differs  from  Fraud 

Exploitation  differs  from  simple  fraud  in  that  it  is  more^ 
subtle,  more  difficult  to  trace  and  expose,  and  ordinarily  gives 
no  grounds  for  legal  action  to  obtain  redress.  In  its  study 
there  is  no  one  act  or  set  of  acts  to  be  listed  and  definitely 
described;  it  takes  an  infinite  number  of  forms  and  in  many 
cases  is  never  known  or  recognized  even  by  its  victims. 

Nor  is  there  any  clear  certainty,  ordinarily,  that  a  company 
has  been  deliberately  exploited,  even  though  it  may  have  been 
v^recked  and  the  facts  as  to  its  management  may  have  become 
known.  It  may  often  be  proved,  of  course,  that  those  in  charge 
of  the  company's  affairs  have  secured  personal  profits  and  that 
the  results  of  the  transactions  out  of  which  they  have  made 
profits  have  been  injurious  to  the  company  which  they  served. 
Yet  the  plea  may  always  be  made  that  mistakes  of  business 
judgment  are  common  to  all  enterprises  and  that  it  is  easy 
to  sit  back  and  criticize  after  the  results  of  a  given  line  of 
action  have  become  known. 

The  Corporate  Form  Favors  Exploitation 

The  general  adoption  of  the  corporate  form  of  organizing 
business  enterprises  has  opened  up  new  and  previously  un- 
thought-of  fields  and  methods  of  exploitation.  The  corporate 
form  is  singularly  well  adapted  for  exploiting  activities. 
Through  the  creation  of  a  small  corporation,  an  individual 

499 


^OO  FINANCIAL   ABUSES   AND   INVOLVEMENTS 

may  wholly  or  partially  hide  his  own  identity  and  rid  himself 
of  personal  responsibility.  The  large  corporation  with  its 
thousands  or  tens  of  thousands  of  shareholders,  few  of  whom 
know  much  about  or  take  a  personal  interest  in  the  fortunes  of 
their  corporation,  offers  an  inviting  opportunity  for  exploita- 
tion. It  requires  a  man  of  really  strong  character  and  of 
unusual  conscientiousness  to  avoid  the  temptation  of  using  an 
important  office  in  a  corporation  of  this  character  for  the  prime 
purpose  of  building  up  his  personal  bank  account.  To  the 
credit  of  corporate  officers  and  directors  it  must  be  said  that  the 
great  majority  devote  their  undivided  efforts  to  the  service 
of  their  corporation  and  the  stockholders  whose  interests  they  ■ 
represent. 

The  legal  fiction  of  "corporate  entity"  which  has  been  more 
rigorously  upheld  and  applied  in  American  courts  than  in 
English  courts,  has  undoubtedly  been  a  highly  important  factor  m 
in  favoring  exploitation.  Any  individual  who  so  desires  may 
readily  organize  and  control  a  corporation  in  which  he  may 
not  personally  appear  either  as  a  director  or  an  officer ;  indeed, 
he  may  not  even  be  on  the  books  as  a  stockholder  of  record. 
With  this  corporate  mask  over  his  face,  the  exploiter  may  go 
ahead  boldly  looking  for  victims,  and  may  even,  under  this 
new  guise,  operate  successfully  on  the  pocketbooks  of  those 
whom  he  has  previously  robbed. 

Petty  Abuses  by  Subordinate  Officers 

In  a  corporation  which  is  conducted  by  able  business  men 
who  are  single-mindedly  devoted  to  the  upbuilding  of  the 
corporation,  it  is  probable  that  nearly  all  subordinate  officers 
will  be  of  the  same  type.  In  the  business  world,  as  everywhere 
else,  like  attracts  like.  Men  who  are  themselves  honorable 
prefer  to  work  under  chiefs  of  the  same  type.  If  they  suspect 
that  their  company  is  being  exploited  by  its  officers,  they 
naturally  seek  an  opportunity  to  leave  and  their  places  are 


EXPLOITATION   BY   OFFICERS  ^OI 

taken  by  men  who  are  perhaps  less  able  or  less  scrupulous. 
There  are,  of  course,  innumerable  exceptions  on  both  sides, 
but  the  general  rule  holds  good.  Consequently,  when  we  find 
a  company  in  which  the  chief  officers  have  been  primarily  en- 
gaged in  exploitation,  it  is  only  too  likely  that  petty  graft  will 
not  be  unknown  among  the  subordinates. 

Under  the  old  regime  of  the  New  Haven  Railroad  Com- 
pany, according  to  the  report  of  the  Interstate  Commerce 
Commission,  the  company  purchased  its  rolling  stock  almost 
exclusively  and  without  competition  from  one  man.  This  man 
sold  the  company  approximately  $37,000,000  of  equipment. 
He  made  no  secret  of  his  generosity  in  making  valuable 
presents  to  the  officials  with  whom  he  did  business,  but  claimed 
that  these  officials  were  old  friends  of  his. 

The  purchasing  officers  of  large  corporations  are  naturally 
subject  to  special  temptations,  inasmuch  as  they  frequently 
control  contracts  of  great  importance.  It  is,  however,  a  very 
rare  occurrence  to  find  even  a  tinge  of  suspicion  resting  on 
these  men,  almost  all  of  whom  command  the  complete  con- 
fidence of  their  associates  and  of  those  with  whom  they  do 
business. 

Exorbitant  Salaries 

In  a  small  corporation  which  has  come  into  the  control 
of  one  faction  and  is  being  exploited  to  the  detriment  of  the 
general  body  of  stockholders,  the  simplest  and  most  common 
method  is  through  payment  of  exorbitant  salaries.  So  long 
as  the  salaries  are  kept  within  the  bounds  of  reason  and  so 
long  as  the  real  purpose — which  is  to  distribute  profits  in 
this  form — is  not  made  too  plainly  evident,  this  practice  is 
legally  unassailable.  It  may,  however,  become  dangerous  to 
the  exploiters  in  case  their  salaries  are  suddenly  jumped,  or 
in  case  there  is  a  rearrangement  of  salaries  which  so  clearly 
corresponds  to  shareholdings  as  to  leave  no  doubt  that  the 


502 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


increases  are  really  mere  devices  for  distributing  dividends  to 
the  dominant  faction  at  the  expense  of  the  other  shareholders. 

Contracts  That  Benefit  Officers 

The  history  of  the  Standard  Rope  and  Twine  Company, 
which  was  formed  in  1895  to  take  over  the  assets  of  the  in- 
solvent United  States  Cordage  Company,  illustrates  some  of 
the  possible  methods  of  exploiting  a  corporation  to  the  per- 
sonal advantage  of  the  officers.  The  first  president  was 
accused — whether  justly  or  unjustly  cannot  be  definitely  de- 
termined— of  discriminating  against  the  Standard  Com- 
pany in  favor  of  a  competing  concern  in  which  he  was  a  part- 
ner, turning  the  less  profitable  contracts  toward  the  former 
and  the  more  profitable  ones  toward  the  latter.  In  1896  the 
president  proposed  that  the  Standard  Company  should  take 
over  certain  processes  controlled  by  him  for  forcing  oil  into 
rope.  The  company  made  a  contract  which  gave  the  presi- 
dent authority  to  spend  $25,000  of  the  company's  money  in 
perfecting  his  invention,  and,  as  a  matter  of  fact,  much  more 
than  this  originally  authorized  amount  was  spent.  In  the 
end  the  process  proved  worthless  and  the  company  had  to 
bear  a  heavy  loss  amounting  to  over  $126,000.* 

One  of  the  worst  scandals  in  American  financial  history 
was  that  connected  with  the  famous  Credit  Mobilier.  In  1864, 
while  the  Union  Pacific  Railroad  was  under  construction,  one 
of  the  vice-presidents  through  a  "dummy"  secured  a  contract 
for  the  construction  of  a  large  section  of  the  line.  This  con- 
tract was  assigned  to  the  Pennsylvania  Fiscal  Agency,  the 
name  of  which  was  later  changed  to  "Credit  Mobilier."  Stock- 
holders of  the  Union  Pacific  were  allowed  to  obtain  Credit 
Mobilier  stock  and  thus  become  stockholders  in  both  concerns. 
As  a  result  of  this  arrangement,  all  incentives  to  economy 
of  construction  were  removed.     Credit  Mobilier  obtained  all 


I 


*Dewing's  "Corporate  Promotions  and  Reorganizations,"  pp.  158,  159. 


EXPLOITATION   BY   OFFICERS  503 

the  contracts  it  cared  for  on  very  attractive  terms,  and  made 
profits  variously  estimated  at  from  $17,000,000  to  $23,000,000, 
in  which  the  officers  of  the  railroad  had  a  large  share.* 

Divergence  of  Business  to  Other  Companies 

A  more  ingenious  and  more  insidious  form  of  exploitation 
for  the  advantage  of  officers  consists  in  diverting  profitable 
business  from  the  corporation  which  the  officers  are  serving  to 
another  corporation  in  which  their  personal  interests  are  larger. 

The  question  as  to  when  an  officer  is  entitled  to  use  for 
his  personal  benefit  knowledge  that  comes  to  him  in  the  per- 
formance of  his  duties  and  when  he  is  under  obligation  to  use 
it  exclusively  for  the  benefit  of  the  corporation,  is  often  puz- 
zling. For  example,  the  manager  of  a  manufacturing  concern 
has  had  brought  to  his  attention  a  new  device  which  is  likely 
to  prove  highly  profitable.  The  information  comes  to  him  as 
an  individual,  not  as  an  officer.  Is  he  entitled  to  organize  a 
new  company  and  to  become  personally  interested  in  the 
manufacture  of  the  device?  Or  is  he  under  obligation  to  turn 
over  the  information  he  has  secured  to  his  company?  As  a 
practical  matter,  probably  few  would  object  if  the  officer,  under 
such  circumstances,  were  to  drop  his  former  connection  and 
devote  himself  to  the  new  enterprise. 

This  leads,  however,  to  the  next  question :  whether  it 
would  be  proper  for  the  officer  to  become  interested  as  a  stock- 
holder and  director  in  the  new  enterprise  without  dropping 
his  connection  as  an  officer.  If  it  is  granted  that  he  may 
properly  do  so,  can  any  objection  be  raised  to  his  permitting 
the  company  which  manufactures  the  new  device  to  do  busi- 
ness with  the  company  of  which  he  is  an  officer?  And,  if  we 
grant  that  the  officer  may  proceed  to  that  extent,  can  objection 
be  raised  to  his  actively  favoring  the  use  of  the  new  device 
by  the  company  of  which  he  is  an  officer? 

♦Daggett's  "Railroad  Reorganization,"  pp.  223,  224. 


504 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


It  will  be  seen  that  the  honest  and  honorable  course  in 
such  matters  is  not  always  clear,  and  men  whose  ideals  of 
business  honor  are  hazy  often  fail  to  keep  on  the  right  side  of 
the  line.  A  director  of  a  corporation  should  regard  himself 
and  act  as  a  trustee  for  the  stockholders  he  represents,  and 
their  interests  should  come  before  his  own. 

"Unloading"  and  Securing  Control  ' 

A  somewhat  different  case  arises  when  the  officers  of  a 
corporation  are  financially  interested  in  another  company 
which  has  proved  to  be  a  money  loser  or  which  needs  assis- 
tance. If  the  business  in  which  they  are  interested  is  in  any 
way  related  to  the  business  of  the  corporation  of  which  they 
are  officers,  it  is  frequently  an  easy  and  tempting  procedure 
to  "unload"  a  portion  of  their  holdings  or  to  secure  financial' 
assistance  in  some  other  form.  The  process  is  especially  easy 
when  the  active  officers  are  able  to  work  together  without 
interference  in  putting  through  their  plans,  and  when  their 
fellow  directors  have  little  direct  personal  knowledge  of  the 
details  of  the  business. 

Sometimes  schemes  of  the  same  general  type  may  be  put 
through  with  a  view  to  enabling  the  officers  to  secure  personal 
control,  for  their  own  benefit,  of  another  company  in  which 
they  are  financially  interested.  By  inducing  the  company  in 
which  they  are  officers  to  take  stock  additional  to  their  own, 
they  may  be  able  to  acquire  the  desired  control. 

It  is  not  necessary  to  say  that  schemes  such  as  these  involve 
a  clear  breach  of  a  director's  duty  and  are  in  themselves  incom- 
patible with  the  higher  standards  of  business  conduct.  Each 
case  must  be  judged  on  its  own  merits. 

Misuse  of  Inside  Information 

Another  common  method  of  exploitation  is  through  the 
misuse  by  officers  or  directors  of  information  which  comes  to 


EXPLOITATION    BY   OFFICERS 


505 


them  on  the  "inside"  but  which  is  unknown  to  other  stock- 
holders and  perhaps  unknown  to  all  other  officers  and  direc- 
tors of  the  corporation.  This  is  most  likely  to  occur  in  con- 
nection with  speculation,  either  in  the  company's  own  shares 
or  in  products  the  price  of  which  can  be  affected  by  the  cor- 
poration's activities. 

As  to  the  misuse  of  inside  information  for  the  purpose  of 
speculating-  in  the  shares  of  their  own  company,  innumerable 
instances  might  be  given.  The  results  are  quite  likely  to  be 
unfortunate  for  the  officers,  themselves,  due  partly  to  the  fact 
that  the  information  upon  which  they  act  is,  in  many  cases,, 
fragmentary,  and  due  also  to  the  fact,  which  many  people 
fail  to  realize,  that  the  up  and  down  movements  of  stock 
market  prices  are  determined  only  in  part  by  the  intrinsic 
merits  of  the  securities.  Fluctuations  arise  more  largely  from 
general  economic  and  market  influences,  with  which  the  offi- 
cers of  most  industrial  corporations  are  not  especially  familiar. 

Is  Exploitation  a  Common  Evil? 

As  has  been  intimated  at  the  beginning  of  this  chapter, 
exploitation  as  a  factor  in  business  transactions  is  perhaps  a 
more  common  evil  than  it  was  in  the  days  when  business  or- 
ganizations were  simpler  and  under  the  more  direct  control  of 
their  owners.  The  officer  or  director  of  the  modern  corpora- 
tion occupies  a  position,  not  merely  of  dignity  and  responsi- 
bility, but  also  of  trust.  This  trusteeship  is  more  clearly 
recognized,  perhaps,  than  was  the  case  a  generation  or  more 
ago.  But  the  ascendency  of  the  higher  standards,  which  are 
implied  in  a  sense  of  trusteeship,  comes  slowly  and  is  the 
result  of  innumerable  hard  struggles.  In  the  meantime,  ex- 
ploitation in  its  myriad  forms  goes  on  apparently  unchecked, 
while,  on  the  surface,  financial  transactions  usually  appear  reg- 
ular, and  plausible  reasons  can  easily  be  advanced  for  ap- 
proving them ;  yet,  once  in  a  while  a  lawsuit  or  an  investigation 


5o6  FINANCIAL  ABUSES  AND   INVOLVEMENTS 

suddenly  tears  away  the  silken  covering  and  reveals  the  ugly 
figures  of  greed  and  graft.  Our  surprise  and  dismay  for  the 
moment  are  acute;  then  we  forget.  We  regain  a  feeling  of 
security  which  remains  until  the  next  unpleasant  incident 
occurs. 

It  seems  probable,  however,  on  the  whole  that  the  sense 
of  business  honor  is  more  developed  today  than  ever  before. 
It  is  certain  that  the  laws  against  corporate  malfeasance  are 
more  stringent  than  before  and  undoubtedly  these  laws  reflect 
a  real  development  of  business  conscience. 


CHAPTER    XXIV 

EXPLOITATION  BY  DIRECTORS  AND  MAJORITY 
SHAREHOLDERS 

Enlarging  the  Circle  of  "Insiders" 

The  preceding  chapter  disclosed  some  of  the  methods  by 
which  the  active  officers  of  a  corporation  may  use  their  posi- 
tions to  carry  through  transactions  which  are  primarily  in 
their  own  interests  and  are  injurious  to  the  interests  of  all 
the  other  shareholders,  including  even  their  fellow  officers 
and  directors  of  the  corporation.  Now  we  have  to  consider 
instances  in  which  the  circle  of  inside  schemers  is  enlarged 
so  as  to  include  all,  or  a  majority,  of  the  members  of  the  board 
of  directors,  who  misuse  their  positions  to  the  injury  of  their 
fellow  shareholders.  The  circle  may  be  enlarged  to  include 
a  majority  of  the  shareholders  who  exploit  the  minority  share- 
holders ;  or  it  may  even  be  further  enlarged  to  include  all  the 
shareholders  who  are  banded  together  for  the  purpose  of 
exploiting  the  creditors. 

The  principal  methods  employed  do  not  differ  funda- 
mentally from  those  previously  described,  and  may  take  the 
form  of  unfair  contracts  with  a  corporation,  or  of  sales  at 
exorbitant  prices,  or  of  misstatements  of  fact,  thus  misleading 
some  of  the  outsiders  into  buying  or  selling  at  far  above  or 
below  fair  valuations,  or  of  misusing  the  resources  of  the 
corporation  to  assist  in  outside  ventures  or  speculations.  These 
are  the  basic  methods  which  in  their  infinitely  varied  forms 
are  used  again  and  again. 

Juggling  Accounts 

Corporate  accounts  and  statements  are  juggled  for  various 
reasons.    One  of  the  most  common  of  these, is  to  make  a  good 

507 


2o8  FINANCIAL  ABUSES   AND   INVOLVEMENTS 

showing  for  the  administration  in  power.  Sometimes  mis- 
leading statements  are  put  out  to  enable  officers  and  directors 
to  buy  or  sell  shares  of  their  own  company  to  advantage. 
Sometimes  promotion  promises  require  dividends  when  divi- 
dends should  not  be  declared  and  the  accounts  are  so  juggled 
as  apparently  to  authorize  these  unjustified  dividends. 

While  the  technical  intricacies  of  juggling  corporate  ac- 
counts so  as  to  present  false  or  misleading  statements  to  the 
general  body  of  shareholders  and  to  the  public  cannot  be  here 
discussed,  it  is  no  doubt  clear  to  every  reader  of  this  volume 
that  many  accounting  entries  are  matters  of  judgment  and 
good  faith;  and  whenever  one  of  these  essentials  is  lacking, 
the  company's  accounting  statements  may  be  technically  ac- 
curate and  yet  may  conceal  the  truth.  There  are  number- 
less variations  in  method. 

The  growing  demand  for  the  proper  auditing  of  cor- 
porate accounts  has  been  a  strong  factor  in  discouraging  their 
juggling.  The  development  of  a  well-educated  financial 
public  has  also  been  a  factor  in  restricting  such  practices. 


"Squeezing"  the  Minority  Stockholders 

As  has  been  indicated  before,  exploitation  is  not  confined 
to  officers  and  directors  as  such.  It  may  be  an  operation  per- 
formed by  or  on  behalf  of  the  majority  shareholders  and 
directed  against  the  minority  shareholders. 

Where  the  majority  stockholders  deliberately  decide  to 
exploit  the  minority,  various  methods  are  open  to  them.  One 
frequently  employed  is  to  let  the  corporate  business  languish 
until  it  is  overwhelmed  with  debt  and  a  reorganization  is 
necessary.  In  this  reorganization  the  minority  interests  suffer, 
or  perhaps  there  is  a  sale  under  execution  at  which  the  ma- 
jority stockholders  buy  up  the  whole  enterprise  at  a  fraction 
of  its  value.  The  same  method  is  sometimes  successfully 
employed  to  ''squeeze  out"  the  majority  stockholders  where 


4 


EXPLOITATION— DIRECTORS— STOCKHOLDERS        509 

these  latter  are  not  in  close  touch  with  the  business  operations 
of  the  company.  Not  infrequently  inventors  have  been  thus 
crowded  out  even  though  they  owned  more  than  50%  of  the 
outstanding  stock  of  the  company  and  therefore  supposed 
themselves  safe. 

A  crude  form  of  exploiting  small  corporations  is  to  elect 
the  majority  stockholders  officers  of  the  company  and  pay  out 
its  profits  to  them  in  the  form  of  excessive  salaries.  Another 
plan  is  to  make  a  special  contract  with  another  company  owned 
by  the  majority  stockholders  so  that  the  profits  of  the  first 
company  go  into  the  treasury  of  the  second  company. 

It  is  impossible  to  recount  here  the  many  ways  in  which 
an  unscrupulous  majority  may  take  advantage  of  the  minority. 
The  foregoing  paragraphs  illustrate  the  general  character  of 
the  methods  used. 

Preventives  of  Exploitation 

Fundamentally  exploitation,  even  though  it  may  take  a 
form  which  is  to  some  extent  sanctioned  by  common  usage, 
is  a  dishonest  process.  Men  who  are  thoroughly  fair  and 
honorable  in  all  their  dealings  will  not  be  misled  into  taking 
action  that  looks  toward  depriving  some  of  their  business 
associates  of  property  or  benefits  to  which  they  are  in  equity 
entitled.  Men  of  high  standards  of  personal  conduct  will  not 
descend  to  using  positions  of  honor  and  trust  for  the  advance- 
ment of  their  personal  fortunes  at  the  expense  of  those  in 
whose  behalf  they  are  supposed  to  act.  Especially  is  this  true 
in  the  large  corporations  with  their  thousands  or  tens  of  thou- 
sands of  stockholders  who  are  attracted  largely  by  the  repu- 
tations of  the  management  and  of  individual  directors.  Out 
of  the  26,544  shareholders  in  the  New  Haven  on  January  i, 
191 5,  10,813  were  women,  3,522  were  trustees  or  guardians, 
and  887  w^ere  insurance  companies  or  other  corporations.  The 
directors  of  this  company  could  well  feel  that  they  were  in 


5IO 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


a  position  of  immense  responsibility  in  handling  the  funds  of 
so  many  thousands  of  dependents. 

Integrity  of  Directors 

The  obvious  remedy  against  exploitation,  it  may  therefore 
be  suggested,  would  be  for  those  shareholders  who  desire 
honest  management  to  elect  only  directors  of  unimpeachable 
honor  or  to  refuse  to  buy  the  securities  of  corporations  which 
do  not  have  such  directors.  As  a  matter  of  fact,  this  is  the 
fundamental  remedy  and  it  is  gradually  being  applied.  But 
human  nature  is  too  slowly  changed  to  make  this  rem.edy 
effective  except  over  a  period  of  generations.  It  is  quite  pos- 
sible that  in  time,  as  corporate  methods  become  better  under- 
stood and  standards  become  better  established,  attempts  at 
exploitation  will  become  comparatively  rare. 

Ethical  Standards  for  Directors 

These  last  remarks  lead  us  back  to  the  difficulties  discussed 
in  the  preceding  chapter  of  determining  when  and  to  what 
extent  a  director  is  morally  justified  in  taking  advantage  of 
his  position  to  make  profits  for  himself.  Certainly  a  director 
who  realizes  that  his  company  is  doing  well  and  has  good 
prospects  is  not  to  be  blamed  for  going  into  the  open  market 
and  purchasing  more  of  its  shares.  In  so  doing  he  merely 
shows  a  proper  confidence  in  the  future  of  his  company.  On 
the  other  hand,  when  his  business  judgment  tells  him  that  dark 
days  are  ahead,  is  there  any  reason  why  he  should  not  sell  his 
shares  to  others  whose  opinion  differ  from  his  own?  The 
distinction  between  what  is  proper  and  what  is  improper  is 
perhaps  to  be  found  in  the  principle  that  the  director  may  buy 
or  sell  as  he  chooses,  so  long  as  he  is  not  basing  his  action  on 
information  that  ought  properly  to  be  made  public.  The 
application  of  that  principle  is  naturally  left  with  each  man's 
conscience. 


I 


EXPLOITATION— DIRECTORS— STOCKHOLDERS        5 1  j 

Minority  Protection  by  Charter  Provision 

Writing  in  the  American  Economic  Review,  Mr.  Mulvey, 
Assistant  Secretary  of  State,  Ottawa,  Canada,  first  discusses 
the  four  methods  named  below  of  tiring  out  the  minority 
stockholders  and  leading  them  to  sell  at  an  abnormally  low 
price : 

1.  Piling  up  huge  undistributed  surplus. 

2.  Making  a  contract  with  a  subsidiary  company  which 

permits  the  subsidiary  to  take  most  of  the  profits. 

3.  Paying  out  profits  in  the  form  of  exorbitant  salaries. 

4.  Selling  out  the  profitable  features  of  the  enterprise 

to  a  new  company  which  is  promoted  by  the  ma- 
jority. 

Mr.  Mulvey  then  points  out  that  all  these  abuses  may  be 
controlled  by  the  charter  or  by-laws,  and  says: 

Salaries  may  be  limited,  the  dealings  with  subsidiary 
companies  for  the  purpose  of  withholding  profits  may 
be  regulated,  methods  of  accounting  may  be  devised 
whereby  dividends  may  not  be  withheld.  A  sale  of  the 
undertaking  may  be  prohibited,  except  with  unanimous 
consent.  The  shareholder  has  a  contract  with  the  com- 
pany which  is  made  up  of  the  statutes,  charter,  and  arti- 
cles or  by-laws.  These  may  be  framed  so  that  exactions 
or  overbearing  methods  of  the  majority  may  be 
eliminated. 

The  objection  to  charter  or  by-law  provisions  placing 
limitations  on  the  operations  of  the  company,  as  Mr.  Mulvey 
suggests,  is  found  in  the  fact  that  such  restrictions  sometimes 
seriously  hamper  the  action  of  the  company.  Provisions  en- 
tirely harmless  at  the  time  they  are  adopted  may  be  outgrown 
or  conditions  may  so  change  as  to  make  their  operation  in- 
jurious. Another  objection  to  the  charter  or  by-law  provision 
as  a  protection  of  the  minority  is  found  in  the  fact  that  these 


:?■ 


i 


^12  FINANCIAL  ABUSES   AND   INVOLVEMENTS 

may  be  omitted  or  amended  if  a  sufficient  vote  can  be  secured, 
and  the  protecting  provisions  be  thus  swept  aside. 

Among  the  charter  or  by-law  provisions  for  protecting 
minority  stockholders  most  commonly  employed  may  be 
enumerated  the  following: 

Cumulative  voting,  whereby  in  elections  for  directors  each 
stockholder  may  cast  the  whole  number  of  his  votes  for  one 
candidate  or  distribute  them  among  two  or  more  candidates 
as  he  may  prefer.  When  this  is  done  the  minority  stock- 
holders— if  they  hold  any  material  amount  of  stock — ^may 
always  secure  representation  on  the  board  of  directors  and 
thus  protect  their  interests. 

Classification  of  stock,  each  class  of  stock  being  given  the 
right  to  elect  one  or  more  directors,  thus  insuring  its  repre- 
sentation on  the  board. 

The  voting  trust  whereby  a  majority  of  the  stock  of  a 
corporation  may  be  placed  in  the  hands  of  trustees  to  be  voted 
by  them  in  favor  of  certain  specified  persons  for  directors  of 
the  corporation. 

Regular  audits.  These  may  be  prescribed  by  charter  or 
by-laws.  They  may  be  annual,  quarterly,  or  held  at  irregular 
intervals,  and  serve  both  as  a  check  on  the  management  and 
a  verification  of  their  accounts. 

Publicity  as  a  Means  of  Minority  Protection 

A  shareholder  in  a  corporation,  large  or  small,  who  feels 
that  he  and  his  associates  are  being  defrauded,  who  has  a 
clear  case  and  who  is  willing,  with  his  eyes  open,  to  enter  into 
a  long  and  gruelling  fight,  is  likely  to  find  simple  publicity  a 
highly  effective,  and,  if  properly  used,  a  highly  legitimate 
method  of  attack.  In  a  large  corporation  the  campaign  of 
publicity  may  be  directed  not  only  toward  stockholders,  but 
toward  the  public  at  large.  In  a  smaller  corporation  it  will 
naturally  be  confined  to  people  who  are  directly  affected. 


EXPLOITATION— DIRECTORS— STOCKHOLDERS        513 

Through  the  use  of  effective  publicity  of  the  best  type 
Justice  Charles  E.  Hughes  carried  through  an  investigation 
of  the  life  insurance  companies  which  at  first  was  quite  insig- 
nificant, but  which  ultimately  brought  about,  through  the  pres- 
sure of  overwhelming  public  sentiment,  a  complete  revolution 
in  the  financial  management  of  the  life  insurance  companies 
and  a  permanent  uplift  in  standards  of  business  morality. 
More  recently,  N.  L.  Amster,  of  Boston,  carried  on  a  cam- 
paign in  behalf  of  the  Rock  Island  stockholders  which  resulted 
in  an  agreement  to  select  by  general  consent  a  new  board 
of  directors  in  whom  all  the  shareholders  can  place  confi- 
dence. 

In  1914,  the  Interstate  Commerce  Commission  used  no 
weapon  except  publicity  in  carrying  through  the  investigation 
of  the  New  Haven  Railroad,  which  revealed  the  true  condi- 
tions and  led — through  pressure  of  public  opinion — to  the 
retirement  of  the  old  management  and  the  election  of  an 
entirely  new  group  of  directors  and  other  ofiftcers. 


CHAPTER    XXV 

INSOLVENCY  AND  RECEIVERSHIP. 

Percentage  of  Failures 

The  niimber  of  business  concerns  which  become  insolvent 
each  year  averages  a  little  below  i  %  of  the  total  number.  Fol- 
lowing is  the  record  for  the  last  ten  years. 


No.  of 

No.  of  Business 

Percentage  of 

Failures 

Concerns 

Failures 

I90S 

11,520 

1,357455 

.85% 

1906 

10,682 

1,392,949 

''?7% 

1907 

11,725 

1,418,075 

.82% 

1908 

15,000 

1,447,554 

1.08% 

1909 

12,924 

1,486,389 

.80% 

I9I0 

12,652 

1,515,143 

.80% 

I9II 

13441 

1,525,024 

.81% 

I9I2 

15452 

1,564,279 

.98% 

I9I3 

16,037 

1,616,517 

•99% 

I9I4 

18,280 

1,655,496 

1.10% 

However,  this  record  does  not  present  a  complete  picture 
for  it  does  not  include  numberless  instances  of  financial  em- 
barrassment which  are  settled  out  of  court.  Nor  does  it  in- 
clude the  still  larger  number  of  cases  where  a  business  concern 
gradually  sinks  its  capital  until  finally  the  enterprise  is  sold 
or  is  transferred  on  some  contractual  arrangement,  thus  bring- 
ing the  enterprise  into  the  hands  of  new  men  who  supply 
fresh  capital  which  is  either  sunk  or  makes  the  business  a 
success.  Sometimes  the  process  of  passing  a  business  concern 
from  hand  to  hand,  each  new  owner  losing  money  until  he 
reaches  the  point  where  he  is  glad  to  hand  it  over  to  som( 
one  else,  is  carried  on  over  a  remarkably  long  period. 

514 


INSOLVENCY   AND   RECEIVERSHIP  glj 

Economic  Insolvency 

This  condition  of  being  unable  so  to  conduct  a  business 
that  its  net  earnings  will  be  more  than  sufficient  to  cover  op- 
erating expenses  and  fixed  charges,  may  be  termed  ^'economic 
insolvency."  If  the  individual  partnership  or  corporation  that 
owns  a  business  of  this  kind  becomes  unable  or  unwilling  to 
put  any  further  capital  into  it,  and  also  is  unable  to  make  an 
adjustment  with  creditors  or  to  find  a  purchaser  for  the  busi- 
ness, then  the  enterprise  may  come  into  the  courts  and  be 
adjudged  bankrupt. 

An  excellent  example  of  economic  insolvency  is  that  of 
the  San  Antonio  Land  and  Irrigation  Company,  Limited, 
which  went  into  voluntary  bankruptcy  on  November  4,  191 4. 
The  company  filed  a  schedule  showing  liabilities  of  over  $8,- 
000,000,  and  assets  of  approximately  $750,000.  It  had  planned 
to  build  a  large  reservoir  to  store  water  for  the  irrigation  of 
60,000  acres  of  land.  When  the  plant  was  completed  the 
district  suffered  from  a  drought  and  the  main  assets  of  the 
company  depreciated  greatly  in  value. 

Economic  insolvency  is  sometimes  defined  as  "the  condi- 
tion of  a  business  enterprise  that  exists  when  the  total  value 
of  assets  is  less  than  the  total  value  of  liabilities."  In  a 
money-losing  corporation  economic  insolvency  will  sooner  or 
later  come,  although  it  is  often  concealed  by  improper  ac- 
counting. 

Technical  or  Financial  Insolvency 

A  second  type  of  insolvency  is  that  which  exists  when 
an  enterprise  that  possesses  a  greater  total  of  assets  than  of 
liabilities  is  unable  to  meet  its  obligations.  This  type  is  some- 
times called  "technical"  insolvency  or  "financial"  insolvency. 
It  may  easily  happen  that  an  enterprise  which  is  a  great  busi- 
ness success  may  in  this  sense  become  insolvent.  There  have 
been  previous  references  to  the  two  insolvencies  and  reorgani- 


5i6  FINANCIAL  ABUSES   AND   INVOLVEMENTS 

zatlons  of  the  Westinghouse  Electric  and  Manufacturing 
Company,  which  has  been  a  big  money-making  enterprise. 
Various  other  examples  have  been  given  of  insolvency  due 
to  lack  of  adequate  working  capital  and  need  not  here  be  re- 
peated. 

This  second  type  of  insolvency  is  probably  more  common 
than  the  first.  It  is  due,  not  to  the  intrinsic  weakness  in  the 
business,  but  to  errors  in  its  financial  management. 

Causes  of  Insolvency 

The  causes  of  failures,  as  summarized  by  the  commercial 
agencies,  may  be  grouped  in  the  following  two  main  classes, 
viz.,  causes  for  which  the  management  of  the  failing  concern 
may  be  held  responsible,  and  outside  factors  over  which  the 
business  can  exercise  little  or  no  control. 

In  the  first  group  we  find  such  causes  as  lack  of  capital, 
incompetence  on  the  part  of  the  management,  the  granting 
of  unwise  credits,  etc.  About  80%  of  all  failures  are  due  to 
this  group  of  causes. 

The  second  class  includes  such  factors  as  losses  by  storms, 
floods,  and  similar  disasters,  unexpected  failures  of  other  con- 
cerns, severe  competition,  etc.  This  group  of  causes  accounts 
for  approximately  20%  of  the  failures  in  the  United  States. 

A  few  of  these  factors  that  are  most  closely  related  to  the 
subject  of  financial  management  will  be  considered  in  the  next 
few  sections. 

Lack  of  Working  Capital 

According  to  the  mercantile  agencies,  the  cause  of  a  little 
more  than  one-third  of  the  legal  insolvencies  in  the  Unitec 
States  is  "lack  of  capital."     This  is  rather  a  vague  phrase 
which  in  the  great  majority  of  instances  should  probably  bej 
interpreted  to  mean  "lack  of  working  capital."     By  far  thej 
greater  number  o|  business  enterprises  can  be  made  successfi 


INSOLVENCY  AND   RECEIVERSHIP 


517 


on  a  small  scale  even  though  their  capital  may  be  very  limited. 
It  is  when  these  enterprises  begin  to  expand  and  go  beyond 
the  prudent  limits  imposed  by  the  small  amount  of  available 
capital,  that  they  tend  more  and  more  to  transfer  working 
assets  into  fixed  assets  and  finally  reach  a  point,  if  care  is  not 
exercised,  where  they  cannot  raise  the  ready  cash  with  which 
to  meet  maturing  obligations.  If  we  were  to  call  the  basic 
trouble  in  such  cases  "mismanagement  of  capital,"  we  should 
not  be  far  from  wrong. 

Anxiety  to  Pay  Dividends 

A  frequent  cause  of  technical  insolvency  among  industrial 
combinations  has  been  excessive  anxiety  on  the  part  of  direc- 
tors to  pay  dividends.  It  has  previously  been  pointed  out 
that  many  industrial  combinations  are  started  on  the  basis  of 
excessive  anticipation  of  profit,  which  has  been  aroused  by 
glowing  prospectuses,  and  the  organizers  feel  called  upon  to 
"make  good."  Dewing  says  that  in  every  one  of  the  cases  of 
failure  cited  by  him,  with  the  exception  of  the  American  Glue 
Company  and  the  possible  exception  of  the  American  Bicycle 
Company,  financial  difficulties  were  not  in  consequence  of  over- 
capitalization, as  is  usually  alleged,  but  the  "direct  cause  of  fail- 
ure in  every  instance  was  deflection  of  working  capital  to  the 
paying  of  interest  and  dividends.  Beneath  these,  as  the  funda- 
mental cause,  was  the  lack  of  judgment  ot  promoters  in  placing 
bonds  upon  an  untried  industrial  enterprise,  and  the  lack  of 
conservatism  of  the  early  management  in  paying  dividends 
without  due  regard  to  sound  principles  of  finance." 

Unfavorable  Market  Conditions 

Another  immediate  cause  of  technical  insolvency,  which 
is  quite  frequent  among  railroad  corporations,  is  inability  to 
meet  maturing  obligations  by  reason  of  market  conditions.  A 
company  may  be  reasonably  sound  and  well  able  to  carry  its 


I  con 

ft 


] 


518  FINANCIAL  ABUSES  AND   INVOLVEMENTS 

load  of  indebtedness  and  yet  may  find  itself  in  no  position,  at 
a  given  period  when  market  conditions  are  unfavorable,  to 
refund  maturing  bonds  or  to  put  out  a  new  issue.  This  situation 
will  very  seldom  arise  with  a  corporation  that  enjoys  reall 
high  credit,  but  it  may  easily  arise  with  those  that  enjoy  onl 
fair  to  medium  credit.  The  fact  that  an  obligation  falls  due  at' 
an  inconvenient  time  may  be  regarded  as  in  one  sense  an  ac- 
cidental misfortune,  though  in  another  sense  the  corporation, 
if  it  had  always  been  well  handled,  would  probably  not  fin(^ 
itself  in  difficulties  wholly  by  reason  of  an  unreceptive  market. 
Though  there  are  other  causes  for  technical  insolvencies, 
the  three  that  have  been  named — deficiency  of  working  capital, 
depletion  of  cash  in  order  to  pay  dividends,  and  maturity  oi 
bonds  or  notes  under  unfavorable  market  conditions — may  b( 
picked  out  as  those  which  are  most  usual. 

Methods  of  Procedure  in  Case  of  Insolvency 

When  a  business  enterprise  is  unable  to  meet  its  debts  and 
is  known  to  be  insolvent,  four  courses  of  action  are  open: 

1.  The  owners  of  the  bonds  and  other  obligations  anc 
their  creditors  may  agree  voluntarily  to  a  "readjustment"  oi 
settlement  of  their  claims.  This  can  be  done  only  when  all  the 
creditors  are  reasonable  and  have  considerable  faith  in  th( 
management  of  the  enterprise.  In  that  case,  they  may  pre- 
fer, for  their  own  sakes,  that  the  situation  should  be  kept 
out  of  the  courts  and  out  of  public  records  and  that  the  busi- 
ness should  go  on  with  as  little  disturbance  as  possible. 

2.  The  corporation  may  voluntarily  dissolve,  divide  it^ 
assets  among  its  creditors,  and  go  out  of  business,  all  without 
the  intervention  of  the  courts. 

3.  The  individual,  the  partnership,  or  the  corporation 
owning  the  enterprise  may  be  adjudged  a  bankrupt,  and  a 
receiver  in  bankruptcy  may  be  appointed  to  dispose  of  th( 
assets  and  distribute  the  proceeds. 


INSOLVENCY  AND   RECEIVERSHIP 


519 


4.  The  corporation  may  secure  the  appointment  of  a  re- 
ceiver in  equity  whose  function  is  to  carry  on  the  business  and 
at  the  same  time  assist,  so  far  as  he  can,  in  working  out  a 
generally  satisfactory  plan  of  reorganization. 

Readjustment  of  Claims 

The  first  of  these  remedies  is  unusual,  except  among  the 
creditors  of  small  corporations.  It  requires  a  degree  of  har- 
monious action  that  is  almost  impossible  to  bring  about  among 
a  great  number  of  people.  The  attempt,  however,  was.  made 
in  July,  191 5,  in  the  case  of  the  Missouri  Pacific-Iron  Moun- 
tain system  under  the  auspices  of  one  of  the  great  banking 
houses  of  America,  Kuhn,  Loeb  and  Company,  who  acted  as 
readjustment  managers.  The  details  of  the  plan  of  readjust- 
ment need  not,  for  this  purpose,  be  considered.  It  was  in 
fact  quite  similar  in  its  general  outline  to  the  reorganization 
plans  which  are  discussed  in  the  chapter  following.  The  point 
that  interests  us  here  is  the  fact  that  in  spite  of  the  obvious 
merits  of  the  plan,  its  remarkably  strong  backing  and  the 
general  indorsement  of  the  financial  press  and  of  financial 
authorities,  the  final  results  were  disappointing.  It  proved 
to  be  impossible  to  secure  the  voluntary  assent  of  all,  or 
practically  all,  the  security  holders,  and  it  was  found  neces- 
sary to  go  through  the  cumbersome  and  expensive  process 
of  reorganization. 

A  similar  attempt  was  made  a  few  years  ago  in  the  case 
of  the  Hudson  and  Manhattan  Company  which  operates  the 
underground  railway  system  through  the  Hudson  River  tunnel. 
In  this  instance  the  number  of  holders  of  obligations  was  much 
smaller  and  the  plan  of  readjustment  was  successfully  carried 
through.  This  plan  is  a  very  common  procedure  with  smaller 
companies  and,  wherever  practicable,  is  usually  by  far  the  most 
economical  and  most  satisfactory  method  of  meeting  a  con- 
dition of  insolvency.    Its  success,  however,  is  always  dependent 


520  FINANCIAL   ABUSES   AND   INVOLVEMENTS 

Upon  the  presence  of  a  fair  degree  of  mutual  confidence  and 
good  faith  among  the  various  parties  concerned. 

Origin  and  Nature  of  Receivership 

A  far  wiser  and  less  wasteful  method  than  bankruptcy 
proceedings  for  handling  the  condition  of  insolvency  in  most 
large  corporate  enterprises,  consists  of  addressing  a  petition 
to  a  court  of  equity  for  the  appointment  of  a  receiver  to  carry 
on  the  business  under  the  supervision  of  the  court,  until  some 
plan  of  reorganization  is  worked  out.  The  petition  is  referred 
to  in  some  jurisdictions  as  a  "bill  in  chancery."  It  may  b( 
presented  by  any  one  of  four  parties :  ( i )  by  the  corporatiot 
itself;  (2)  by  the  stockholders  of  the  corporation;  (3)  by  the 
secured  creditors;  (4)  by  the  unsecured  creditors. 

Applications  from  the  corporation  itself  or  from  its  own 
stockholdeus  are  rare,  and  are  still  more  rarely  granted.  Ap- 
plications from  creditors  who  are  friendly  toward  the  cor- 
poration are  frequently  presented,  however,  and  in  such  cases 
the  court  is  often  requested  to  appoint  one  of  the  officers,  or 
some  one  else  close  to  the  management,  as  receiver.  "Friendly 
receiverships,"  as  these  arrangements  are  known,  are  not 
always  warmly  favored  by  the  bondholders  and  other  creditors 
who  are  usually  somewhat  suspicious  of  the  management  that 
is  responsible  for  involving  the  company  in  financial  diffi- 
culties. 

Conflicting  Receiverships 

An  application  for  a  receivership  may  be  addressed  to  any 
court,  either  federal  or  state,  which  has  jurisdiction  over 
any  part  of  the  business  of  the  corporation.  As  a  result  it 
has  often  happened  that  two  or  more  courts  have  each  ap- 
pointed a  receiver  and  these  receiverships  have  conflicted  with 
each  other. 

It  has  been  not  uncommon  for  the  federal  and  the  state 


INSOLVENCY   AND   RECEIVERSHIP 


521 


courts  to  come  Into  conflict  in  this  manner.  The  tendency, 
however,  has  been  strong  toward  putting  all  receivership  pro- 
ceedings that  affect  interstate  corporations  into  the  hands  of 
the  federal  courts;  and  these  courts  almost  invariably,  as  a 
matter  of  courtesy  to  each  other,  act  in  harmony.  The  judge 
who  first  appoints  a  receiver,  is  usually  accorded  precedence 
and  other  judges  appoint  the  same  man  as  receiver  of  the 
property  over  which  they  have  jurisdiction.  Sometimes  the 
incipient  conflict  is  solved  by  the  appointment  of  an  ancillary 
receiver,  who  is  expected  to  co-operate  strictly  in  harmony 
with  the  receiver  first  appointed. 

Dissolution  of  Insolvent  Corporations 

The  dissolution  of  an  insolvent  corporation  and  the  distri- 
bution of  the  assets  is  an  uncommon  proceeding.  It  requires 
the  consent  both  of  creditors  who  must  trust  to  the  good  faith 
of  the  officers  of  the  corporation  in  carrying  through  the  disso- 
lution and  distribution  of  the  proceeds,  and  also  of  the  share- 
holders who  must  be  convinced  that  no  other  procedure  is  pos- 
sible. 

It  IS  the  feeling  among  creditors  and  shareholders  alike, 
that  those  who  have  managed  a  corporation  which  has  become 
insolvent,  should  not  be  left  free  to  make  their  own  arrange- 
ments for  winding  up  the  company,  but  should  be  checked 
and  supervised  by  some  responsible  officer  who  will  unearth 
the  facts.  It  is  because  of  this  feeling  that  the  remedies  of 
voluntary  readjustment  and  of  dissolution  are  so  seldom 
used,  and  that  the  remedies  of  bankruptcy  and  receivership  are 
almost  always  necessary. 

Voluntary  Dissolution 

Dissolutions  are  not  always  due  to  insolvency,  but  may 
come  as  the  result  of  pressure  of  other  kinds  or  as  the  result 
of  a  conviction  on  the  part  of  a  majority  of  the  shareholders 


^22  FINANCIAL   ABUSES   AND   INVOLVEMENTS 

that  the  corporation,  while  not  actually  insolvent  or  losing 
money,  is  nevertheless  making  an  unprofitable  use  of  the  capital 
invested  and  is  actually  tending  to  deteriorate.  Under  these 
conditions,  it  may  often  be  the  part  of  wisdom  to  bring  about  a 
dissolution  while  the  company  still  possesses  a  valuable  surpliis. 
A  number  of  special  cases  of  partial  dissolution — which  might 
also  be  described  as  a  partial  distribution  of  assets — have  arisen 
in  the  United  States  recently,  due  to  decrees  of  the  courts  re- 
quiring ''combinations  in  restraint  of  trade"  to  resolve  them- 
selves into  their  constituent  elements.  The  practical  applica- 
tion of  these  decrees  has  in  many  cases  involved  peculiar  diffi- 
culties. 

Instances  of  Voluntary  Dissolution 

Ordinarily  there  is  no  special  financial  skill  required  in 
order  to  handle  the  process  of  liquidation,  which  consists  simply 
of  gradually  closing  down  the  business,  disposing  of  the  assets, 
and  distributing  the  proceeds  to  creditors  and  shareholders. 
Yet  even  this  comparatively  simple  procedure  involves  a  vast 
amount  of  detail  work. 

In  the  spring  of  19 14  the  management  of  the  United  States 
Express  Company  decided  that  in  the  face  of  the  competition 
for  express  business,  and  particularly  on  account  of  the  com- 
petition of  the  newly  established  parcel  post,  it  would  be  best 
for  the  company  to  liquidate  its  assets  and  withdraw  from  the 
field.  After  the  decision  was  announced  the  first  step  was  to 
arrange  for  the  transfer  to  other  express  companies  of  its  valu- 
able contracts  and  of  many  of  its  physical  assets.  Fortu- 
nately, there  was  little  duplication  of  contracts  or  facilities 
among  the  express  companies  and  most  of  this  property  could 
be  disposed  of  to  the  remaining  express  companies  at  reason- 
able appraised  valuations. 

It  was  necessary  to  make  complete  inventories  and  this 
proved  to  be  so  long  a  task  that  in  many  cases  wagons,  horses, 


INSOLVENCY  AND   RECEIVERSHIP  ^23 

office  furniture,  leases,  etc.,  were  transferred  first  and  valued 
afterwards.  The  equipment  used  by  the  United  States  Ex- 
press Company  in  New  York  City  represented  an  investment 
of' between  $350,000  and  $400,000.  Over  90%  of  the  em- 
ployees of  the  United  States  Express  Company  were  taken 
over  by  the  other  large  express  companies.  The  remaining 
10%  were  made  up  largely  of  employees  who  were  retained 
in  the  service  of  the  United  States  Express  Company  during 
the  process  of  liquidation. 

Origin  and  Nature  of  Bankruptcy 

In  the  early  English  law  an  individual  was  declared  bank- 
rupt for  the  purpose  of  enabling  his  creditors  to  seize  upon 
and  distribute  his  assets.  In  case  the  assets  did  not  prove  suf- 
ficient to  meet  his  debts,  he  was  held  personally  subject  to  the 
remaining  claims  of  his  creditors,  and  in  default  of  payment 
was  thrown  into  jail.  Within  the  last  150  years,  however, 
the  popular  and  legal  conceptions  of  bankruptcy  have  been 
greatly  modified. 

The  purpose  of  bankruptcy  proceedings  is  no  longer 
merely  to  protect  creditors,  but  also  to  free  the  individual 
from  a  load  of  debt  that  has  become  insupportable  and  set 
him  on  his  feet  again  as  a  useful  member  of  society.  There 
are  abuses,  to  be  sure,  of  this  modern  practice.  Cases  are 
not  unknown,  both  of  individuals  and  of  business  enterprises, 
that  have  gone  through  bankruptcy  proceedings  for  the  prime 
purpose  of  clearing  themselves  of  the  legal  obligation  to  pay 
their  debts  and  afterwards  have  refused  to  recognize  any 
moral  obligation.  But  these  abuses  are,  after  all,  compara- 
tively rare.  Individuals  who  have  been  able  to  rebuild  their 
fortunes,  after  having  gone  through  bankruptcy,  have  often 
made  it  a  point  of  honor  to  repay  in  full  all  the  debts  from 
which  they  had  legally  been  freed. 

Bankruptcy  proceedings  in  the  United  States  are  governed 


524 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


by  the  National  Bankruptcy  Act  of  1898,  and  the  courts  having 
jurisdiction  are  those  of  the  Federal  Government. 

Two  Kinds  of  Bankruptcy 

Bankruptcy  is  of  two  general  kinds,  voluntary  and  in- 
voluntary. The  benefits  of  bankruptcy  are  open,  not  only  to 
natural  persons,  with  a  few  exceptions,  but  also  to  business 
corporations  except  those  engaged  in  railroad  operation,  in- 
surance, or  banking.  These  three  lines  of  business  are  of  such 
general  importance  that  it  was  thought  not  to  be  in  the  public 
interest  to  permit  their  operations  to  be  brought  suddenly  to  a 
close  and  their  assets  scattered.  The  process  of  winding  up 
banking  and  insurance  companies  is  provided  for  under  the 
National  and  State  Banking  and  Insurance  Acts.  The  defini- 
tion of  "insolvency"  as  given  in  the  National  Bankruptcy  Act 
is,  from  a  legal  standpoint,  peculiar,  although  it  conforms  to 
the  definition  of  "economic  insolvency"  that  has  been  given 
above.  A  person  is  insolvent,  within  the  meaning  of  the  bank- 
ruptcy law,  "when  the  aggregate  of  his  property,  exclusive  of 
any  property  that  he  has  conveyed,  transferred,  concealed  or 
removed,  or  permitted  to  be  removed  with  intent  to  hinder, 
delay  or  defraud  his  creditors,  is  not,  at  a  fair  valuation,  suffi- 
cient in  amount  to  pay  his  debts."  An  individual  or  a  cor- 
poration being  in  a  condition  of  insolvency,  must  then  commit 
an  "act  of  bankruptcy"  if  the  person  or  the  corporation  is  to 
be  thrown  into  involuntary  bankruptcy. 

The  most  common  act  of  bankruptcy  is  the  making  of  a 
general  assignment  for  the  benefit  of  creditors.  As  a  general 
rule,  a  voluntary  assignment  for  the  benefit  of  creditors  is  less 
expensive  than  bankruptcy  proceedings.  It  requires  honor, 
mutual  confidence,  and  good  faith,  while  on  the  other  hand 
bankruptcy  procedure  is  especially  valuable  in  case  there  is 
any  suspicion  of  misrepresentation  or  dishonesty.  Bankruptcy 
is  a  harsh  and,  for  most  corporations,  a  fatal  remedy  for  in- 


INSOLVENCY  AND   RECEIVERSHIP 


525 


solvency.  It  is,  in  fact,  hardly  worth  while  to  attempt  to 
rehabilitate  a  corporation  that  has  gone  through  bankruptcy. 
It  is  usually  far  easier  and  better  to  form  a  new  corporation 
which  will  purchase  the  assets  and  proceed  to  carry  on  the 
business. 

Receivers'  Powers  and  Duties 

The  purpose  for  which  a  receiver  In  equity  is  appointed, 
is  usually  quite  different  from  the  purpose  of  a  receiver  or  trus- 
tee in  bankruptcy.  The  latter  aims  first  to  take  possession  of 
all  the  property  of  the  insolvent  individual  or  concern;  next  to 
dispose  of  the  property  as  quickly  as  is  practicable;  and  third, 
to  distribute  the  cash  that  has  been  realized.  A  receiver  in 
equity,  on  the  other  hand,  has  for  his  function  to  keep  the 
business  running  as  smoothly  and  with  as  little  loss  as  possible. 
He  may  make  some  changes  in  methods  of  administration  and 
may  properly  retrench  whenever  he  can  do  so  without  impair- 
ing the  efficiency  of  the  property,  but  in  general  he  carries  on 
the  business  in  about  the  same  manner  in  which  any  business 
is  carried  on.  He  aims  not  to  turn  the  assets  into  cash,  but 
to  keep  working  as  profitably  as  possible.  Not  infrequently 
the  property  of  a  corporation  could  not  be  sold  for  an  amount 
sufficient  even  to  reimburse  the  secured  creditors ;  yet  as  a  going 
concern  it  may  be  able  to  earn  normal  profits.  This  is  the 
case,  in  fact,  with  almost  all  companies  that  have  become 
technically  insolvent.  They  are  not,  in  the  first  place,  properly 
subject  to  the  Bankruptcy  Act  since  their  assets  certainly 
exceed  their  liabilities,  and  to  attempt  to  wind  them  up  would 
be  poor  policy  for  every  one  concerned.  The  best  and  most 
common  procedure  with  all  such  insolvent  corporations,  as 
well  as  with  banks,  insurance  companies,  and  railroads,  is  to 
arrange — usually  through  friendly  proceedings — for  the  ap- 
pointment of  a  receiver  to  conduct  the  business  while  negotia- 
tions for  its  reorganization  are  in  process. 


526 


FINANCIAL   ABUSES   AND   INVOLVEMENTS 


The  receiver  carries  on  his  work  under  the  direct  authority 
and  supervision  of  the  judge  who  has  appointed  him.  The 
closeness  of  this  supervision  depends  to  a  large  extent  on 
the  personalities  of  the  judge  and  of  the  receiver,  the  general 
practice  of  the  court,  and  numerous  other  factors.  In  gen- 
eral, the  receiver  makes  it  a  point  to  secure  special  authority 
for  acts  that  cannot  be  regarded  as  a  part  of  the  routine  of 
conducting  the  business. 

Under  authority  of  the  court,  a  receiver  may  issue  obliga- 
tions known  as  "Receiver's  Certificates"  which  constitute  a 
claim  on  the  company's  income  and  assets  ranking  ahead  of 
all  other  claims.  He  may  secure  new  equipment,  bring  new 
blood  into  the  management,  find  new  methods  of  marketing 
the  company's  products,  and  inaugurate  new  systems  of  opera- 
tion. He  is,  in  fact,  the  general  manager  of  the  company 
for  the  time  being,  with  very  little  restriction  upon  his  actions. 
Sometimes  a  receiver  will  remain  in  control  for  two  or 
three  years  or  more  before  a  satisfactory  plan  of  reorganiza- 
tion is  worked  out.  It  has  been  remarked  above  that  the 
receiver  is  frequently  one  of  the  previous  operating  officials; 
on  the  other  hand,  it  sometimes  happens  that  the  receiver 
makes  so  satisfactory  a  record  that  he  is  requested,  after  the 
reorganization  has  been  completed,  to  become  an  operating  offi- 
cial and  continue  to  work  out  the  policies  which,  as  receiver, 
he  has  inaugurated.  F.  W.  Whitridge,  for  example,  after 
successfully  operating  the  Third  Avenue  Railroad  Company 
in  New  York  City  as  receiver,  became  and  until  his  death  con- 
tinued to  be  president  of  the  reorganized  company. 

Customary  Results  of  Receivership 

It  is  frequently  the  case  that  a  corporation  which  becomes 
insolvent  has  for  several  years  been  running  downhill,  either 
because  of  incompetence  or  exploitation  on  the  part  of  the 
management,  or  because  the  impaired  credit  of  the  company 


INSOLVENCY  AND  RECEIVERSHIP  527 

has  not  permitted  it  to  raise  new  capital  with  which  to  bring 
its  plant  and  equipment  up  to  modern  requirements.  The 
appointment  of  a  receiver,  instead  of  being  another  step  down- 
ward, may  prove  to  be  the  company's  salvation.  That  depends 
in  part,  of  course,  on  the  character  and  ability  of  the  receiver. 
If  he  is  a  man  of  ideas  and  of  executive  talent,  he  may  quickly 
rejuvenate  the  organization.  As  has  just  been  noted,  he  has 
the  power  to  issue  receiver's  certificates  and  thus  secure 
funds  which  had  previously  been  lacking.  Sometimes  a  com- 
paratively small  amount  of  new  capital  will  be  enough  to  put 
a  decaying  corporation  back  into  a  moderately  sound  condition. 
The  receiver  has  a  free  hand.  If  it  is  possible  to  do  anything 
for  the  corporation  and  if  he  is  the  man  to  do  it,  the  results 
of  his  activities  may  be  a  gratifying  gain  in  efficiency  and 
earning  power.  In  any  event,  the  receiver  should  be  able  to 
hold  the  organization  and  the  property  intact  and  to  turn 
back,  after  his  service  is  completed,  a  going  and  profitTmaking 
business. 

Ordinarily  the  receiver  takes  some  part  also  in  an  informal 
way  in  the  negotiations  for  financial  reorganization  of  the 
business  and  advises  with  the  court  as  to  the  plan  of  reorgani- 
zation that  ought  to  be  approved.  It  is  an  object  of  his  efforts 
to  bring  about  the  reorganization  and  thus  terminate  the  re- 
ceivership at  the  earliest  possible  moment. 

Very  infrequently  it  happens  that  these  customary  results — 
maintenance  of  a  going  business  and  financial  reorganization 
— are  not  attainable.  And  in  that  case  the  receivership 
may  finally  end  in  a  forced  winding  up  of  the  business.  Al- 
though unusual,  it  is  possible  even  for  a  railroad,  like  other 
business  enterprises,  actually  and  completely  to  go  out  of  busi- 
ness. In  October,  19 14,  the  judge  having  jurisdiction  signed 
an  order  directing  the  receivers  of  the  Buffalo  &  Susquehanna 
Railroad  to  discontinue  permanently  the  operation  of  trains,  to 
take  up  the  company's  rails,  and  to  dispose  of  its  assets.    It  is 


528 


FINANCIAL  ABUSES  AND   INVOLVEMENTS 


stated  that  the  total  population  served  by  this  railway,  which 
was  86  miles  in  length,  was  only  about  17,000;  consequently 
the  railroad  was  wholly  unable  to  pay  its  own  operating  ex- 
penses. At  the  time  when  the  receiver  wound  up  the  business, 
all  that  was  left  to  the  owners  of  $6,000,000  par  value  out- 
standing bonds  (to  say  nothing  of  outstanding  preferred  and 
common  shares)  was  the  scrap  value  of  the  rails  and  rolling 
stock,  the  right  of  way,  and  23  acres  of  land  fronting  on  Lake 
Erie. 


CHAPTER    XXVI 
REORGANIZATION 

Purpose  of  Reorganization 

In  England  the  term  "reconstruction"  is  used  to  describe 
the  process  that  we  ordinarily  call  "reorganization."  The 
English  word  is  better  chosen  as  it  embodies  the  idea  which, 
underlies  the  whole  process;  that  of  tearing  down  the  old 
financial  structure  and  using  the  materials  in  a  new  and 
stronger  structure. 

Financial  reorganization,  in  its  proper  sense,  is  not  merely 
a  series  of  compromises  and  forced  sacrifices  imposed  upon 
security  holders.  It  is  a  rearrangement  of  the  company's  lia- 
bilities so  as  to  make  them  conform  more  closely  to  the  assets 
and  earnings.  If  it  is  worked  out  on  ideal  lines  the  reorganiza- 
tion may  be  described  as  a  new  financial  plan  which  replaces 
the  old  plan  that  has  proved  faulty.  The  readjustment  of  the 
company's  finances  should  enable  it  to  proceed  thereafter  under 
more  favorable  conditions  and  to  achieve  better  results. 

In  each  reorganization  there  are  one  or  two  specific  pur- 
poses that  stand  out  with  especial  prominence.  The  specific 
purposes  that  are  most  commonly  found  are  the  following : 

To  raise  more  capital. 
To  reduce  fixed  charges. 
To  simplify  the  financial  structure. 
To  give  increased  facilities  for  raising  capital  in  future. 
To  eliminate  unprofitable  branches  of  the  business. 
To  pay  or  "refund"  pressing  obligations. 
To  take  care  of  an  accumulation  of  unpaid  preferred 
dividends. 

529 


530 


FINANCIAL   ABUSES   AND   INVOLVEMENTS 


The  final  plan  of  reorganization  must  be  approved  by  a 
sufficient  number  of  security  holders  and  must  also  have  the  ap- 
proval of  the  court.  The  relative  influence  of  the  security 
holders,  on  one  side,  and  of  the  judge  and  receiver,  on  the 
other  side,  varies  greatly  in  determining  the  plan  of  reorganiza- 
tion ;  and  it  is  probable  that  in  complicated  reorganizations,  es- 
pecially those  of  railroads,  it  is  more  often  necessary  for  the 
courts  to  intervene  and  take  an  active  part  in  formulating  a 
plan  than  it  is  in  the  simpler  cases  of  reorganization,  particu- 
larly of  industrial  corporations. 

Conflicts  of  Interests  in  Reorganization 

The  various  interests  which  are  concerned  in  a  financial  re- 
organization may  ordinarily  be  classified  in  three  groups,  as 
follows : 

1.  The  creditors,  including  both  the  holders  of  floating 

debt  and  the  bondholders. 

2.  The  shareholders,  both  preferred  and  common. 

3.  The  banking  houses  which  are  figuring  on  the  under- 

writing of  the  reorganization  plan. 

In  a  complicated  reorganization  each  one  of  these  three 
groups  is  subdivided.  There  may  be  a  number  of  bond  issues 
which  have  claims  that  in  part  conflict  with  each  other.  The 
interests  of  the  preferred  and  of  the  common  shareholders 
are  by  no  means  identical.  There  may  be  two  or  more  bank- 
ing houses  that  are  working  on  the  reorganization  with  an  eye 
to  handling  the  underwriting.  It  may  often  happen,  therefore, 
that  there  is  a  complex  struggle  among  the  various  groups  of 
interests.  On  some  questions  there  may  be  agreements  and 
alliances  between  two  or  more  groups,  and  on  other  questions] 
the  cleavage  may  be  entirely  different. 

Naturally  the  chief  influence  is  exerted  by  the  bondholders,! 


REORGANIZATION 


531 


especially  by  the  holders  of  those  issues  which  are  well  pro- 
tected by  prior  liens. 

Next  come  the  holders  of  the  junior  lien  issues.  The  bank- 
ing houses  are  likely  to  be  in  close  touch  with  all  the  different 
groups  of  bondholders  and  advise  with  them.  Inasmuch  as 
the  active  assistance  of  some  good  banking  house  is  essential 
in  order  to  make  any  plan  a  success,  the  representatives  of 
these  houses  are  likely  to  be  consulted  and  to  have  a  voice 
in  determining  all  important  questions.  Moreover,  they  are 
in  the  advantageous  position  of  an  outsider  who  may  be  trusted 
to  view  the  situation  impartially. 

As  for  the  shareholders  in  a  drastic  reorganization,  they 
have  little  to  say.  Indeed,  it  sometimes  happens  that  their 
claims  to  recognition  are  ruthlessly  brushed  aside  and  they  are 
practically  wiped  out  of  existence.  However,  as  we  shall  see, 
they  are  more  commonly  needed  in  order  to  supply  the  fresh 
cash  required  for  the  reorganized  company,  and  for  that 
reason  are  permitted  to  have  some  voice  in  working  out  the 
reorganization  plan.  The  officers  of  a  failed  corporation  some- 
times undertake  to  direct  the  reorganization  but  their  efforts 
are  seldom  welcomed.  The  receiver,  as  we  have  seen,  some- 
times takes  a  fairly  active,  though  informal,  part  in  working 
out  the  reorganization  plan. 

Formation  of  Committees 

In  present-day  practice  one  of  the  immediate  results  of 
the  announcement  of  insolvency  of  an  important  corporation 
is  the  formation  of  a  number  of  security  holders'  committees, 
each  one  representing  a  certain  security  issue.  Sometimes  one 
committee  may  represent  two  or  more  issues,  the  interests  of 
which  are  not  conflicting.  The  process  of  formation  of  these 
committees  is  nearly  always  something  of  a  mystery.  They 
seem  to  spring  up  sometimes  overnight  without  special  au- 
thority.    As  a  matter  of  fact  they  are  usually  self-appointed 


532 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


and  each  committee  is,  in  reality,  simply  a  group  of  individuals 
who  have  determined  among  themselves  that  it  is  wise  and 
proper  for  them  to  solicit  authority  from  their  fellow  security 
holders  to  act  in  their  behalf. 

In  order  to  secure  this  authority,  it  is  essential  that  the 
members  of  the  committee  should  either  be  personally  well 
known  to  the  security  holders  or  should  be  connected  with  im- 
portant firms  or  banking  houses.  In  large  reorganizations 
membership  on  these  committees  is  regarded  as  something  of 
a  prize.  The  members  are  frequently  allowed  generous  fees 
for  their  services  and  do  not,  as  a  matter  of  fact,  have  many 
onerous  duties.  The  detailed  work  is  usually  handled  by  the 
secretary  of  the  committee  or  by  counsel.  However,  it  would 
be  an  injustice  to  fail  to  point  out  that  many  reorganization 
committees  composed  of  able  men  devote  a  great  amount  of 
time  and  effort  to  their  work  and  sometimes,  especially  in  the 
smaller  reorganizations,  give  their  services  without  compen- 
sation. 

Even  in  the  latter  case,  the  fees  of  attorneys  for  the 
various  reorganization  committees  must  be  provided  for  in  the 
reorganization  plan.  Payments  must  be  made  to  the  managers 
of  the  reorganization  and  to  the  banks  or  trust  companies  which 
act  as  depositories  for  securities.  The  receiver's  fees,  plus  the 
fees  of  the  attorneys  who  advise  with  him,  are  nearly  always 
heavy.  And,  finally,  there  are  numerous  incidental  expenses 
and  fees  for  services  of  accountants,  for  advertising  and  cir- 
cularizing in  connection  with  the  reorganization  plan,  and  so 
forth,  which  aggregate  a  large  amount.  The  expenses  of  re- 
organization are  so  heavy  that  members  of  reorganization  com- 
mittees are  likely  to  persuade  themselves  that  it  makes  little 
difference  if  they  include  a  liberal  compensation  for  themselves. 

The    self-appointed   committee    for   a    certain    group   ofp 
security  holders  does  not  always  meet  with  instant  acceptance. 
Security  holders  are  likely  to  be  somewhat  skeptical.    Unless! 


REORGANIZATION 


533 


most  of  the  large  holders  are  represented  in  the  reorganization 
committee,  they  are  likely  to  start  an  opposition  committee  and 
there  may  be  an  active  struggle  for  proxies.  If  the  opposition 
committee  is  at  all  successful,  there  may  be  later  a  merger  of 
two  committees,  for  it  is  clearly  essential  that  there  should  not 
be  dissension  among  any  one  group  of  security  holders. 

In  the  normal  course  of  events,  after  several  committees 
have  been  formed  these  committees  begin  to  negotiate  with 
each  other  and  with  the  receiver  with  a  view  to  arranging  the 
best  possible  terms  for  the  interests  they  represent.  It  is  hardly 
possible  for  any  general  agreement  to  be  reached  except  by  a 
protracted  series  of  negotiations  and  compromises  and  there 
must  be  some  supreme  judge  or  arbiter.  Unless  the  receiver, 
some  official  of  the  company,  or  some  influential  person  or 
banking  house  can  assume  this  function  and  really  take  charge 
of  the  whole  process  of  bringing  about  an  agreement,  it  is 
natural  and  customary  to  select  from  the  various  security 
holders'  committees  a  group  which  includes  at  least  one  repre- 
sentative of  each  set  of  interests  that  must  be  taken  into  con- 
sideration; this  group  is  customarily  known  as  the  "Reor- 
ganization Committee."  This  is  the  committee  that,  in  the 
final  analysis,  devises  the  plan  of  reorganization.  The  various 
security  holders'  committees  may  negotiate,  but  they  are  likely 
to  follow  the  lead  of  their  representative  on  the  general  re- 
organization committee  and  in  reality  do  little  more  than  give 
their  public  approval  to  the  final  reorganization  plan. 

In  spite  of  its  drawbacks,  including  the  ever-present  pos- 
sibility that  not  all  the  security  holders'  committees  will  con- 
scientiously represent  the  interests  entrusted  to  their  care,  the 
committee  method  of  working  out  a  reorganization  plan  is  in 
most  cases  the  only  practical  method.  In  a  large  corporation 
meetings  of  the  security  holders  are  quite  impracticable;  and 
if  they  were  held  they  would  be  utterly  useless  so  far  as  work- 
ing out  a  plan  is  concerned. 


534 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


The  committee  plan  might  be  used  more  frequently  in 
smaller  corporations,  the  security  holders  of  which  cannot 
effectively  express  their  will.  In  a  recent  instance  the  majority 
shareholders  of  an  oil-producing  company  were  believed  by  the 
minority  party  to  have  driven  the  company  into  bankruptcy. 
The  sale  of  its  property  and  assets  had  been  ordered  by  the 
Federal  Court  and  a  so-called  "Reorganization  Committee" 
composed  of  former  officials  was  planning  to  bid  for  the  com- 
pany at  this  sale.  At  the  last  moment  some  of  the  minority 
shareholders  appointed  themselves  a  committee,  secured  the 
co-operation  of  a  good  proportion  of  the  outstanding  shares, 
employed  a  capable  law^yer  and  incurred  other  necessary  ex- 
penses which  did  not  constitute  a  heavy  burden  on  any  individ- 
ual shareholder,  and  presented  their  objections  to  the  court. 
These  objections  were  sustained,  and  in  the  end  the  committee 
forced  the  adoption  of  a  new  and  much  more  equitable  plan. 
In  this  instance  the  prompt  and  courageous  action  of  a  few 
small  shareholders  checked  what  probably  amounted  to  a  con- 
spiracy to  obtain  full  control  of  the  property. 

Procedure  in  Reorganization 

The  first  step  in  a  reorganization  after  some  person  or 
group  of  persons — receiver,  banking  house,  reorganization 
committee,  or  some  one  else — has  been  permitted  to  take 
charge  of  the  process  is  to  bring  about  a  thorough  examination 
and  analysis  of  the  accounts.  It  may  be  extremely  unsafe  to 
accept  without  question  the  accounting  statements  issued  by 
the  old  management,  for  it  is  quite  likely  that  their  natural 
effort  for  several  years  has  been  to  conceal  the  company's 
growing  financial  weakness.  Until  the  actual  earnings  and 
expenses  are  definitely  determined,  no  plan  of  reorganization 
that  will  hold  water  can  be  worked  out.  The  examination 
may  be  both  expensive  and  lengthy.  While  it  is  in  progress, 
those  actively  engaged  in  the  reorganization  may  carry  on 


REORGANIZATION 


535 


negotiations  and  work  out  a  tentative  plan,  but  no  final  result 
can  be  accomplished. 

The  second  step  consists  of  carrying  on  or  completing  the 
negotiations.  Inasmuch  as  most  of  the  members  of  the  security 
holders  and  reorganization  committee  who  must  be  consulted 
are  likely  to  be  men  of  affairs  devoting  only  a  relatively  small 
amount  of  time  and  thought  to  the  reorganization  scheme, 
these  negotiations  are  troublesome  and  are  likely  to  cover 
a  long  period  of  time  before  any  definite  conclusions  are 
reached. 

In  the  meantime,  as  a  third  step,  the  receiver  will  be  con- 
ducting the  company  with  all  possible  economy.  Perhaps,  as 
set  forth  in  the  preceding  chapter,  he  will  be  raising  new 
capital,  reforming  the  internal  organization,  and  otherwise 
raising  the  enterprise  to  a  higher  plane  of  ef^ciency.  If  the 
company  possesses  non-essential  or  non-profit-making  propn 
erty,  the  receiver  may  proceed,  with  the  consent  of  the  court, 
to  dispose  of  some  of  its  property.  This,  again,  may  be  a 
long-drawn-out  process. 

The  final  step,  when  the  reorganization  plan  has  been 
worked  out  and  accepted  both  by  the  security  holders  and  by 
the  court,  is  to  select  and  put  into  execution  the  best  legal 
method  of  accomplishing  the  financial  rearrangement  that  has 
been  agreed  upon.  In  case  the  unanimous,  or  almost  unanimous 
consent  of  the  security  holders  has  been  obtained,  the  court 
may  declare  the  plan  operative  and  binding  even  upon  the 
small  proportion  that  have  not  given  their  assent.  It  is  more 
frequently  necessary,  however,  to  go  through  the  legal  form 
of  organizing  a  new  corporation — usually  with  a  name  very 
similar  to  that  of  the  insolvent  corporation — and  to  bring 
about  a  judicial  sale  of  all  the  property  of  the  old  corporation 
to  the  new  corporation.  The  reorganization  committee  in  that 
case  will  turn  in  the  obligations  of  the  old  corporation  in  pay- 
ment for  the  property,  and  will  issue  in  exchange  obligations 


536  FINANCIAL  ABUSES   AND   INVOLVEMENTS 

and  shares  of  the  new  corporation  under  the  terms  that  have 
been  agreed  upon. 

Sometimes  stubborn  security  holders  of  the  old  corporation 
who  are  opposed  to  the  reorganization  plan  refuse  to  exchange 
their  securities  for  those  of  the  new  corporation.  The  result 
may  not  be  especially  pleasing  to  them,  for  they  are  likely  to 
be  left  holding  securities  of  a  company  which  is  non-active 
and  for  all  practical  purposes  may  be  called  non-existent. 
When  the  reorganization  of  the  Northern  Pacific  Railroad 
Company  took  place  in  1896,  the  holders  of  some  25,000 
shares  refused  to  exchange  them  for  shares  in  the  Northern 
Pacific  Railway  Company  (the  new  company).  Because  of 
their  opposition  the  old  company  is  still  kept  alive  but  is,  of 
course,  inactive. 

Raising  Fresh  Capital 

Usually  the  most  urgent  problem  in  a  reorganization  is  to 
bring  in  fresh  capital,  either  for  the  purpose  of  making  addi- 
tions and  betterments  in  the  fixed  assets,  or  more  commonly 
for  the  purpose  of  providing  adequate  working  capital.  In 
either  case  it  is  necessary,  in  almost  every  reorganization,  to 
secure  a  considerable  amount  of  cash.  If  the  company  had 
been  well  supplied  with  cash  it  would  not  presumably  have 
become  insolvent.  But  the  fact  that  a  company  is  in  receivers' 
hands  is  naturally  no  recommendation  to  prospective  pur- 
chasers of  its  securities,  and  the  problem  of  raising  ca?h  is 
therefore  not  only  urgent  but  often  extremely  difficult.  It  can 
be  solved  only  by  enforcing  drastic  sacrifices  on  security 
holders.  There  are  three  possible  methods  of  raising  new 
capital  or  of  securing  an  equivalent  reduction  in  current  lia- 
bilities : 

I.  By  bringing  out  new  issues  of  bonds  or  shares  which 
are  well  secured  and  are  offered  on  terms  particu- 
larly favorable  to  purchasers. 


REORGANIZATION  537 

2.  By  levying  assessments  on  bond  or  share  holders. 

3.  By  inducing  the  current  creditors,  or  some  of  them,  to 

accept  funded  obHgations  in  payment  of  the  amounts 
due  them. 

In  case  the  insolvent  company's  credit  has  not  already  been 
used  to  the  limit,  it  may  be  possible  to  bring  about  some  rear- 
rangement of  claims  upon  assets  and  earnings  which  will  leave 
room  for  the  issuance  of  new  securities.  These  securities  may 
then  be  sold  at  a  heavy  discount  and  thus  the  cash  most 
urgently  needed  may  be  obtained. 

The  second  method  of  raising  cash  is  through  assessment. 
In  nearly  every  reorganization  the  common  shareholders  are 
requested  to  pay  some  assessment  in  order  to  secure  any  hold- 
ings in  the  reorganized  company.  The  same  requirement  is 
frequently  imposed  upon  the  preferred  shareholders  and  is 
sometimes  imposed  even  upon  the  junior  bondholders.  It  may 
seem  strange  that  a  bondholder  or  even  a  preferred  shareholder 
should  be  compelled  to  pay  out  fresh  money  in  order  to  hold 
an  interest  in  the  company;  but  the  truth  is  that  any  security 
holder  who  is  not  amply  protected  by  marketable  assets  is 
likely  to  face  this  experience.  If  he  resists  the  proposal  a  new 
company  is  organized  which,  at  the  judicial  sale,  will  turn  in 
the  prior  lien  securities  in  payment  for  all  the  property  of 
the  company.  This  automatically  wipes  out  the  junior  bond- 
holders— unless  they  choose  to  raise  the  capital  with  which  to 
pay  off  the  prior  lien  holders,  in  which  case  they  will  hold  the 
whip-hand.  The  junior  bondholders  or  shareholders  are  thus 
left  with  the  clear  alternative  of  either  giving  up  their  previous 
investment  without  any  further  effort  to  protect  and  redeem 
it,  or  of  paying  the  assessment. 

The  question  as  to  whether  a  shareholder  should  or  should 
not  pay  his  assessment  is  always  one  to  be  studied  with  much 
care.    Naturally  the  reorganization  managers  will  endeavor  to 


538  FINANCIAL  ABUSES   AND   INVOLVEMENTS 

make  terms  that  will  be  at  least  fairly  attractive  in  order  to 
insure  that  the  money  which  is  required  shall  be  forthcoming. 
For  this  reason  it  is  usually  profitable  for  shareholders  to  pay 
up  their  assessment.  Daggett  states  that  in  almost  all  cases 
of  railroad  reorganization  the  price  of  the  securities  obtained 
by  the  assessment  payer  was  within  six  months  nearly  equal 
to  the  previous  market  quotation  plus  the  assessment.  In 
practically  every  case  later  quotations  have  gone  much  higher. 
The  increase  in  value  "has  abundantly  justified  the  payments 
which  stockholders  were  asked  to  make."  Probably  the  most 
drastic  assessment  on  record  is  that  of  the  Houston  and  Texas 
Central  Railroad  Company  in  1897,  which  amounted  to  73% 
on  the  common  shares. 

The  third  method  of  increasing  cash  resources — that  of 
inducing  the  current  creditors  to  accept  long-term  securities 
in  settlement  of  their  claims — is  practicable  only  when  the  in- 
solvent company  is  fundamentally  prosperous  and  has  been 
brought  into  difficulties  merely  through  a  temporary  shortage 
in  working  capital.  In  both  the  Westinghouse  reorganizations 
the  holders  of  floating  debt  were  easily  persuaded  to  take  long- 
term  notes  and  bonds  in  payment,  for  they  were  convinced  of 
the  company's  inherent  soundness.  In  the  first  reorganiza- 
tion of  1 89 1  the  company's  $3,000,000  in  floating  debts  were 
replaced  largely  by  stock  issues. 

Reducing  Fixed  Charges 

In  the  majority  of  cases  of  insolvency  the  trouble  has 
arisen  primarily  because  the  company  had  a  larger  load  of 
fixed  charges  than  its  income  would  permit  it  to  carry.  That 
being  the  case,  the  only  safe  and  correct  course  in  reorganiza- 
tion is  to  cut  down  these  charges.  It  is  useless  to  continue 
them  unless  the  company's  difficulties  are  partly  temporary; 
for  to  do  so  would  be  simply  to  invite  a  new  insolvency. 

One  of  the  simplest  and  most  severe  cases  of  cutting  down 


REORGANIZATION 


539 


fixed  charges  is  that  of  the  reorganization  of  the  Northern 
Pacific  Railroad  Company  in  1875.  The  company's  Hne  was 
at  that  time  still  under  construction  and  its  earnings  were  less 
than  3/2  of  1%  on  its  funded  debt.  There  seemed  to  be  no 
immediate  prospect  of  increasing  the  earnings  and  it  was 
therefore  determined  that  all  fixed  charges  should  be  eliminated. 
All  outstanding  bonds  were  replaced  by  preferred  shares ;  float- 
ing debt  was  also  exchanged  for  preferred  shares;  and  old 
common  shares  were  replaced  by  new  common  shares. 

Daggett  points  out  that  out  of  seven  railroad  reorganiza- 
tions in  the  period  from  1893  to  1898,  every  one  showed  a  de- 
crease in  fixed  charges  averaging  31%.  He  suggests  that 
experience  shows  the  advisability  of  keeping  in  view,  in  the 
rearrangement  of  fixed  charges,  the  five  following  principles : 

1.  The   maximum   fixed   charges   after  the   reorganiza- 

tion is  completed  should  not  exceed  the  absolute 
minimum  of  net  earnings. 

2.  As   large   a   proportion   as    possible   of   the    charges 

should  consist  of  interest  on  bonds,  avoiding  sink- 
ing funds,  guaranteed  dividends,  rentals,  and  the 
like. 

3.  The   losses   should   fall   most   heavily  on   the    junior 

security  holders  generally,  leaving  the  first  lien 
securities — unless  the  reorganization  is  exceedingly 
drastic — practically  untouched. 

4.  While  fixed  charges  should  be  cut,  the  nominal  value 

of  the  new  securities  received  by  security  holders 
in  the  old  company  should  be  reduced  as  little  as 
possible. 

5.  Bondholders  whose  claims  are  scaled  down  should  be 

given  a  corresponding  chance  to  participate  in  fu- 
ture increases  of  earnings.* 


^Daggett's    "Railroad    Reorganization,"   pp.   357-362. 


540 


FINANCIAL   ABUSES   AND   INVOLVEMENTS 


If  the  junior  bondholder  who  is  asked  to  accept  a  reduc- 
tion in  the  principal  and  possibly  in  the  rate  of  interest  of  his 
holdings,  is  at  the  same  time  given  preferred  and  common 
shares  up  to  the  full  par  value  of  his  former  bondholdings,  or 
perhaps  a  little  above,  he  is  inclined  to  accept  the  reduction 
much  more  readily.  He  may  feel,  quite  properly,  that  there 
is  at  least  a  chance  of  his  recovering  in  future  all  the  capital 
that  he  has  lost. 

As  to  industrial  reorganizations,  Dewing  has  averaged  the 
results  of  :ij  companies,  and  finds  that  fixed  charges  were  re- 
duced on  the  average  about  25%.  This  percentage  probably 
measures  fairly  well  the  excessive  amounts  of  bonded  and 
other  obligations  which  were  issued  above  the  limits  of  pru- 
dence under  the  old  financial  plan. 

The  tendency  on  the  whole  has  been  more  and  more 
strongly  toward  avoiding  half-way  measures  in  reorganizations 
and  toward  putting  the  corporation  on  its  feet  financially  so 
that  it  will  not  within  a  short  time  come  back  into  the  hands  of 
the  financial  surgeons.  To  illustrate  this  tendency,  an  interest- 
ing parallel  may  be  drawn  between  the  first  reorganization  of 
the  Erie  Railroad  in  1859  and  its  reorganization  in  1895  by 
which  time  the  present-day  methods  and  principles  of  reorgani- 
zation had  become  well  recognized.  In  the  first  reorganization 
fixed  charges  were  not  reduced,  preferred  shares  were  given  in 
exchange  for  the  unsecured  indebtedness,  the  second  mortgage 
which  was  about  to  fall  due  was  extended,  and  an  assessment 
of  2j4%  was  levied  on  both  preferred  and  common  shares. 
The  position  of  the  road  was  not  much  stronger  after  the  reor- 
ganization than  it  had  been  before,  and  the  money  paid  in  by  the 
shareholders  was  dissipated  without  permanent  benefit  either 
to  the  corporation  or  to  themselves.  The  reorganization  of 
1895,  on  the  other  hand,  lowered  fixed  charges,  procured  am- 
ple cash  by  assessments  on  the  shareholders,  and  gave  shares 
rather  than  bonds  in  exchange  for  the  new  cash  raised. 


REORGANIZATION  ^^I 

Effect  on  Financial  Structure 

One  customary  result  of  reorganization  is  an  increase  in 
capitalization.  At  first  glance  this  may  seem  surprising,  but 
it  is  the  necessary  result  of  the  policy  of  compensating  the  old 
security  holders  for  their  sacrifices  by  giving  them  some  form 
of  claim  on  the  future  earnings  of  the  corporation.  Junior 
bondholders  are  usually  asked  to  accept  a  percentage  of  new 
bonds  plus  a  percentage  of  preferred  shares,  the  new  securities 
having  a  total  nominal  value  at  least  equivalent  to  the  nominal 
value  of  the  bonds  they  formerly  held.  The  preferred  share- 
holder is  perhaps  asked  to  pay  an  assessment  and  accept  new 
securities  consisting  of  preferred  and  common  shares.  The 
common  shares  may  be  reduced  or  wiped  out,  but  more  often, 
upon  payment  of  assessment,  are  replaced  by  shares  of  not 
greatly  reduced  nominal  value.  In  general,  the  tendency  is 
strongly  toward  reducing  bond  capitalization  and  increasing 
the  share  capitalization  more  than  proportionately. 

Another  customary  result  in  large  corporations  is  the  sim- 
plification of  the  company's  financial  structure.  In  the  years 
preceding  reorganization  the  company  has  in  all  probability 
put  out  various  issues  of  bonds,  preferred  shares,  and  com- 
mon shares,  some  of  which  may  have  conflicting  or  uncertain 
claims.  Reorganization  gives  an  opportunity  to  replace  these 
various  small  issues  by  a  few  large  issues.  At  the  same  time, 
increased  facilities  for  raising  capital  in  future  are  often  pro- 
vided. The  new  issues  are  made  large  enough  to  provide  for 
the  immediate  needs  of  the  reorganized  company,  with  the 
proviso  that  additional  bonds  may  be  sold  under  the  same  mort- 
gage on  fulfillment  of  the  conditions,  set  forth  in  the  deed  of 
trust.  Through  this  simplification  and  provision  for  future  cap- 
ital requirements  the  company's  financial  structure  may  be 
brought  into  line  with  the  best  present-day  practice.  This  is 
often  one  great  advantage  of  reorganization. 

Another  advantage  frequently  aflForded  by  a  reorganization 


542  FINANCIAL   ABUSES   AND   INVOLVEMENTS 

is  the  opportunity  to  eliminate  unprofitable  branches  or  de- 
partments. Sometimes  the  bondholders  who  are  secured  by  a 
mortgage  or  a  branch  or  an  isolated  plant  are  bluntly  told 
that  they  may  take  the  property  which  is  not  wanted  by  the 
parent  corporation.  More  often,  the  fact  that  the  property  to 
which  they  have  a  claim  is  not  essential,  is  driven  home  and 
they  are  forced  to  agree  to  a  considerable  reduction  in  their 
claims,  which  may  be  sufficient  to  put  the  outlying  branch  or 
plant  on  a  profitable  basis.  Reorganization  is  apt  to  be  car- 
ried on  in  a  cold-blooded  way  by  financial  men  who  are  im- 
pressed only  by  results  that  have  actually  been  achieved.  Fre- 
quently the  main  difficulty  with  a  business  that  has  become  in- 
solvent has  been  overoptimism  and  overexpansion  on  the 
part  of  its  management.  Wherever  that  is  the  case,  a  reor- 
ganization which  eliminates  these  outside  ventures  or  reduces 
the  expense  of  conducting  them  may  prove  of  great  and  lasting 
benefit  to  the  corporation. 

Reorganizations  for  Special  Purposes 

An  extremely  simple  reorganization  which  did  not  in  any 
way  afifect  the  financial  structure  of  the  company  was  that  of 
the  American  Woolen  Company  of  New  Jersey  in  August, 
191 5.  This  reorganization  is  fully  explained  in  the  following 
extract  from  the  official  statement  issued  at  the  time : 

The  American  Woolen  Company  is  essentially  a  New 
England  organization.  With  but  one  exception  all  its 
plants  are  located  in  New  England;  its  executive  head- 
quarters are  in  Boston;  its  largest  mills  are  situated  in 
Massachusetts;  a  very  large  number  of  its  stockholders 
are  Massachusetts  people;  the  bulk  of  its  taxes  is  paid  in 
Massachusetts;  and  most  of  its  financing  is  done  in 
Massachusetts.  For  these  and  other  reasons,  including 
important  advantages  offered  by  the  corporation  and 
taxation  laws  of  Massachusetts,  it  is  the  opinion  of  your 
directors  that  the  interests  of  your  Company  as  a  corpo- 


REORGANIZATION  543 

ration  and  of  the  stockholders  individually  will  be  best 
served  by  rechartering  the  Company  as  a  Massachusetts 
corporation. 

It  is  proposed  that  the  new  corporation  shall  issue 
amounts  of  preferred  and  common  stock  equal  to  those 
now  outstanding  of  the  New  Jersey  corporation,  to  wit, 
$40,000,000  of  preferred  stock  and  $20,000,000  of  com- 
mon stock;  and  that  the  relative  rights  and  interests  of 
preferred  and  common  stockholders  with  respect  to 
preferences,  dividends,  voting  rights,  etc.,  shall  be  the 
same  in  the  Massachusetts  corporation  as  they  now  are 
in  the  New  Jersey  corporation.  The  final  result  of  the 
proposed  proceedings  will  be  that  the  assets  and  good- 
will of  the  New  Jersey  corporation  will  be  vested  in  the 
Massachusetts  corporation,  which  will  issue  its  preferred 
and  common  stock  as  above  stated.  The  directors  and 
other  officers  of  the  Massachusetts  corporation  will  be 
those  of  the  New  Jersey  corporation,  with  the  exception 
of  two  inactive  members  of  your  board,  one  of  whom  is 
a  resident  of  New  Jersey.  In  other  words,  with  the  ex- 
ception of  some  minor  differences  rendered  essential  by 
the  statutes  of  Massachusetts,  the  rights  and  interests  of 
the  stockholders  in  the  new  corporation  will  be  those  in 
the  old  corporation. 

A  not  uncommon  reason  for  a  simple  reorganization  is  the 
desire  to  take  care  of  accumulated  unpaid  dividends  on  pre- 
ferred share  issues.  When  a  corporation,  after  a  long  period 
of  small  profits  during  which  it  has  been  impossible  to  keep 
up  payments  of  preferred  dividends,  reaches  a  stage  of  pros- 
perity that  appears  likely  to  be  lasting,  the  common  share- 
holders are  often  impatient  at  the  prospect  of  continuing  for 
some  years  the  slow  process  of  paying  up  the  back  dividends 
while  in  the  meantime  the  common  shareholders  receive 
nothing.  On  the  other  hand,  the  preferred  shareholders,  if 
they  feel  confidence  in  the  continued  large  earning  power  of 
the  company,  may  be  entirely  willing  to  accept  securities  in 
lieu  of  cash  in  settlement  of  their  dividend  claims.     In  1914 


544 


FINANCIAL  ABUSES   AND   INVOLVEMENTS 


the  directors  of  the  Western  Power  Company  formulated  3 
plan  of  this  kind  for  funding  back  dividends  amounting  to  iS% 
which  had  accumulated  on  the  company's  $6,000,000  of  6%. 
preferred  stock.  In  substance  the  plan  provided  for  a  new 
corporation — the  Western  Power  Corporation — which  would 
have  $7,080,000  preferred  shares  at  a  par  value  of  $100  per 
share,  and  146,700  common  shares  without  par  value.  $118 
in  new  preferred  was  offered  for  each  $100  of  the  old  pre- 
ferred ;  while  the  new  common  was  exchanged  share  for  share 
for  the  old  common. 

A  very  simple  method  of  reorganization  when  a  going  cor- 
poration needs  more  cash,  is  to  persuade  all  the  shareholders  to 
turn  back  to  the  company  a  given  proportion  of  their  holdings, 
and  then  to  resell  this  treasury  stock  for  cash.  This  is  a  method 
commonly  used  among  textile  mills  where  the  issuance  of 
bonds  is  objectionable  because  of  their  bad  effect  on  the  bank 
credit  of  the  companies  operating  in  this  field.  The  plan  is 
obviously  unworkable  if  any  shareholder  objects,  and  is  applic- 
able therefore  only  to  corporations  having  but  a  small  num- 
ber of  shareholders. 

Reorganization  to  Secure  Control 

A  manufacturing  corporation  in  a  small  eastern  city  had 
been  built  up  over  a  long  period  of  years  by  its  president  and 
general  manager.  It  was  originally  ow^ned  by  the  president 
as  an  individual  but  later  was  incorporated  and  shares  were 
taken  by  some  of  his  leading  officials.  At  the  time  of  his  death 
the  business  was  capitalized  at  $600,000,  of  which  the  president 
owned  $489,000,  the  general  manager — who  had  become  the 
active  operating  head  of  the  plant — $80,000,  and  the  remain- 
ing shares  were  scattered  among  other  operating  officials. 
After  the  president's  death  his  estate  was  handled  by  trustees 
who  were  desirous  of  putting  the  property  into  a  well-secured 
form  and  did  not  wish  to  take  any  active  part  in  the  manage- 


REORGANIZATION 


545 


ment  of  the  business.  On  the  other  hand,  the  general  man- 
ager was  anxious  to  obtain  control.  Under  these  conditions, 
it  was  determined  that  the  shares  held  in  the  president's  estate 
should  be  exchanged  in  part  for  bonds  of  the  corporation  and 
in  part  for  preferred  shares.  Inasmuch  as  the  executors  of 
the  estate  desired  to  withdraw  a  large  part  of  the  capital  from 
the  business  in  order  to  make  a  more  diversified  investment, 
it  was  further  determined  that  the  corporation  and  the  execu- 
tors should  co-operate  in  carrying  through  a  sale,  to  outsiders, 
of  the  preferred  shares  held  by  the  estate. 

A  new  corporation  was  then  organized  which  issued  $200,- 
000  in  bonds,  $200,000  in  preferred  shares,  and  $200,000  in 
common  shares,  and  which  gave  its  securities  in  exchange  on 
an  agreed  basis  for  the  common  shares  of  the  old  company. 
The  estate  was  still  left  with  a  small  block  of  common  shares 
upon  which  the  general  manager  took  an  option.  In  the  mean- 
time, in  order  to  secure  his  control,  a  voting  trust  agreement 
was  entered  into  which  gave  the  general  manager  full  power 
to  name  a  majority  of  the  board.  A  sales  campaign  was  then 
started  to  dispose  of  the  preferred  shares.  Inasmuch  as  the 
corporation  took  part  in  the  campaign,  it  was  conducted  in 
such  a  manner  that  no  injury  to  the  credit  of  the  corporation 
resulted.  It  is  understood  to  have  been  entirely  successful.  The 
general  manager  has  exercised  his  option  for  the  purchase  of 
the  estate's  holdings  of  the  common  shares ;  and  the  final  result, 
therefore,  is  highly  satisfactory  to  all  parties  concerned. 

The  various  purposes  of  reorganization  are  so  numerous 
that  they  cannot  all  be  discussed.  The  general  principles  set 
forth  and  illustrated  in  this  chapter,  however,  can  always  be 
utilized.  Unless  there  is  deliberate  unfairness  or  stupidity  on 
the  part  of  some  of  the  interests  concerned,  it  is  always  pos- 
sible to  work  out  a  scheme  of  readjustment  or  reorganization 
that  will  serve  the  best  interests  of  all  parties. 


INDEX 


Acceptances,  iii,  391,  407 
Accounting, 

relation  to  financing,  3 
Accounts, 

commercial,  advances  on,  407-409 

instalment,  advances  on,  407 

juggling,  507 

trade,  115 
Accounts   payable,  iii 
Accounts  receivable, 

as  collateral,  120 
Advertising  agency, 

financing  an,  226 
Agreements,  syndicate,  34S 
^ktiengesellschaft,  23 
American  Malting  Corporation, 

estimation  of  earnings,  186 
American  Telephone  and  Telegraph 
Company, 

number  of  stockholders,  37 
American  Woolen  Company, 

reorganization  of,  542 
Amortization, 

principal  methods  of,  163 
Annual   report, 

American  practice,  35 

English  practice,  36 
"Assembling"  a  proposition,  240 
"Assenting"  stock,  85 
Assessments, 

in  reorganization,  537 
Assets, 

adjustment    of    capitalization   to, 
189 

copyrights,  191 

good-will,  191-197 

increment  of,  468 


intangible,  depreciation  of,  426 
intangible,    represented    by    com- 
mon stock,  75 
patents,  191 
"quick,"  357 

distinction  from  cash,  405 
relation    to    security   issues,    212, 

218 
stock  preferred  as  to,  ^z 
tangible,    represented    by    bonds 

and  preferred  stock,  75 
three  divisions  of,  218 
working, 
converting  into  cash,  405 
relation  to  gross  sales,  384 
Associations, 

under  deeds  of  trust,  20 
Auction, 
England,      "Model     Auction 

Clause,"  309 
selling  securities  at,  308 

B 

Bank  collateral,  120 

Bank  credit  (See  also  "Credit*") 

abuse  of,  117 

form  of  borrowed  capital,  116 
Bank   loans, 

factors  considered,  123 
Bankruptcy, 

kinds  of,  524 

origin  and  nature  of,  523 
,      Bankruptcy  Act,  524 
Banks, 

calculating   extension   of   capital, 
368 

source  of  capital  funds,  203 

547 


54^ 


INDEX 


Betterment  expenses, 

concealment  of,  429 
Betterments, 

charged    to    operating    expenses, 
428 

investing  in,  370 

two  classes  of,  431 
Bill  in  chancery,  520 
Bills  of  exchange,  394 
Bills  of  lading, 

as  collateral,  121 
Bills  receivable, 

as  collateral,  120 
Bonds, 

adaptation  of,  to  market,  209 

as  collateral,  120 

assessment  on,  in  reorganization, 

537 

bearer  form,  140 

"closed,"    136 

collateral  trust,  147 

convertible,  158 

corporate,   137 

coupon  form,  140 

debenture,  149 

denomination  of,  138 

equipment  trust,  145 

form  of  long-term  borrowing,  131 

income,  154 

issues, 
choosing  the  right  kind,  212 
handling  of  by  brokers,  320 
relation  to  gross  earnings,  497 
.   limited  open  end,"  136 

mortgage,  141 

Erie  Railroad,  142 

"open,"  136 

participating,  158 

registered,  140 

safeguarding  of,  170 

security  behind,  140 

selling    (See  also  "Selling  secur- 
ities") 
on  stock  exchange,  328 


special  provisions  and  forms  of, 
219 
Bonus  in  stock,  91 
Borrowing    money,    7     (See    also 

"Capital") 
"Broken  lot"  of  stock,  67 
Brokerage,  322 
Brokers, 

as  speculators,  332 

commission  of.  New  York  Stock 
Exchange,  330 

handling  of  security  issues,  320 

limitation  of  sale  through,  324 

obligations  of,  322 

requirements  of,  326 
Budgets,  482-488 

cash,  488 

classification  of  expenses,  488 

continual  revision,  485 

income,  487 

income  vs.  cash  basis,  485 

monthly,  487 

nature  and  types  of,  482 

objections  to,  483 

use  of,  482 
Business, 

diverged  to   other  companies  by 
officers,  503 

volume  of,  384 
Business    finance      (See    "Financ- 

ing") 
By-laws  of  corporation,  33 


Calculating  income,  417 
Calumet   and   Hecla   Mining  Com" 
pany, 
dividend  record,  449 
Canada, 
corporations,  expense  of  organiz- 
ing, 58 
voting  power  of  preferred  stock, 

79 


INDEX 


549 


Capital,   (See  also  "Capital  funds") 
additional,  299 
adjusted  to  earnings,  299 
advantages  of  borrowing,  105 
borrowed, 

forms  of,  no 

long-term,  131-171 

long-term,  bonds,  131 

long-term,  mortgages,  131 

proportions  of,  108 

short-term,  105-130 

short-term,  bank  credit,  116 

trade-credit  as  form  of,  in 
calculating   extension   of,    for    a 

bank,  368 
distinction    between    owned    and 

borrowed,  65 
estimating  requirements,  354 
fixed,  355 

calculating,  363 

relative  amount  of,  to  working, 
378 
investing  in  betterments,  370 
investing  in  extensions,  364 
owned,  65-104 

percentage  of  net  returns  to,  182 
raising    cash,    in    reorganization, 

536 
"revolving,"  355 
surplus  as  a  source  of,  478 
total,  relation  to  working,  490 
working,  355 

affected  by  period  of  manufac- 
ture, 381 

affected  by  terms  of  purchase, 
388 

affected  by  terms  of  sale,  392 

affected  by  turnover,  384 

calculating     requirements     for, 

380-414 
effect  of  seasonal  changes,  412 
factors  that  affect,  361 
factors  to  be  considered,  380 
for  instalment  selling,  401 


m  new  proposition,  247 
lack  of,  516 

necessity  for  adequate,  357 
relative    amount   of,    to    fixed, 
^    378 
Capital  funds, 
banks  and  institutions  as  a  source, 

203 
investing  public  as  a  source,  203 
investment     associations     as     a 

source,  204 
investment  of,  354-379 
sources  of,  201-228 
speculative  public  as  a  source,  205 
Capitalization,  172-200 
adjustment  to  assets,  189 
adjustment  to  earnings,  184 
basis  of,  173 
definition  of,  172 
investment  as  basis,  175 
of  development  expenses,  178 
of  earning  power,  179-186 
of  initial  expenses  and  losses,  177 
of  organizing  expenses,  178 
of  public  service  companies,  199 
of  surplus,  197 

percentage  of  net  returns  to,  182 
railroad,  per  mile,  215 
recapitulation  by  stock  dividends, 

197 
relation  to  gross  sales,  181 
Cash, 
budgets,  488 

converting  working  capital  into,  405 
paying  dividends  with,  453 
Cash  resources,  493 
Central  of  Georgia  Railway  Com- 
pany, 
income  bonds,  155 
Centralization, 

avoidance  of,  62 
Certificates,  stock,  86 
in  "bearer"  form,  87 
"registered,"  87 


550 


INDEX 


Chain  stores, 

human  equation  in,  i88 
Charters,  corporation,  27 

revision   to  prevent   exploitation, 

511 
Claflin,  H.  B.,  Company, 

credit  of,  119 

notes  of,  119 
Claims, 

readjustment  of,  in  case  of  in- 
solvency, 519 
"Clayton  Bill,"  40 
Collateral, 

accounts  receivable  as  basis,  120 

basis  for  bank  credit,  120 

bills  of  lading  as  basis,  121 

bills  receivable  as  basis,  120 

bonds  as  basis,  120 

cotton  as  basis,  I2i 

live  stock  as  basis,  122 

merchandise  as  basis,  120 

personal  property  as  basis,  121 

stock  as  basis,  120 

warehouse  receipts  as  basis,  121 

wheat  as  basis,  121 
Collateral  trust  bonds,  147 
Colorado  Fuel  and  Iron  Company, 

management  of,  62 
Combinations    (See  also  "Promot- 
ing combinations") 

basis  of,  275 

difficulties  of  forming,  269 

English,  typical,  279 

fields  for,  267 

forming,  to  secure  control,  286 

"horizontal,"  265 

industrial,  development  of,  265 

making  them  successful,  289 

preliminary  investigation,  273 

promotion  of,  265-290 

small,  analysis  of,  282 

"vertical,"  265 
Commercial  accounts, 

advances  on,  409 


Commercial  Credit  Company, 

loans  against  notes,  410 
Commercial  loans, 

factors  considered,  123 
Commercial  Security  Company, 

method    of    financing    instalment 
accounts,  408 
Commissions, 

charged   by   underwriting   syndi- 
cates, 348 

on  sale  of  securities,  322 
Committees, 

formation   of,   in   reorganization, 
531 
Common  stock, 

adequate  income  for  dividends,  217 

distinction     from     "ordinary 
shares,"  70 

effect  of  limitation  to,  214 
Companies   Act, 

Dominion  of  Canada,  79 
Compensation, 

of  directors,  41 
Competition, 

regulation  of,  by  combination,  265 
Consolidated    Cotton    Duck    Com- 
pany, 

syndicate  operations  with,  351 
Consolidations,     281       (See     also 
"Combinations"     and     "Pro- 
moting combinations") 
Contracts, 

instalment,   399 

that  benefit  officers,  502 

with   directors,   43 
Control, 

reorganization  to  secure,  544 

securing,  by  officers,  504 
Conversion, 

preferred  into  common,  81 
Convertible  bonds,  158 
Copyrights, 

valuation  of,  191 
Corporate  deeds  of  trust,  133 


INDEX 


551 


I 


Corporate  form,  45-63 

advantages  of,  54 

disadvantages  of,  56 

efficiency  of,  59 

favors  exploitation,  409 
Corporations,  25-44    (See  also  "Cor- 
porate form"  above) 

advantages    of    corporate    form, 

54 
by-laws,  33 
charter,  2^ 

choosing  the  security  issue,  212 
classes  of  stock,  30 
close,  48 
disadvantage  of  corporate  form, 

56^ 
dissolution  of  insolvent,   521 
distinction     from     other     forms, 

17 

expense  of  organizing,  58 
fiction  of  corporate  entity,  26 
governmental  control  of,  57 
holding  companies,  49 

legality  of,  51 
illegal  combinations,  50 
importance  of,  45 
internal  regulations  of,  33 
name,  29 

non-competitive,  51 
"non-stock,"  47 
open,  48 

operation    in    different    jurisdic- 
tions, 31 
operation  in  foreign  countries,  32 
origin  of,  25 
ownership, 

continuity  of,  56 

distribution  of,  54 

liability  of,  54 
principal  business  office,  30 
purposes,  29 

smaller,  selling  stock  of,  208 
small,  the  number  of,  46 
subsidiary,  52 


transfer  of  ownership,  54 
trusts,  50 
Cotton  as  collateral,  121 
Credit, 
bank,  116 
abuse  of,  117 

abuse  of,  Claflin,  H.  B.  Com- 
pany, 119 
basic  principles  of,  123 
statements  required,  124 
unwritten  rules  of,  125 
"lines"  of,  407 
of  a  corporation,  57 
trade,  iii 
Creditors,  exploitations  of,  507 
Cumulative,    preferred    stock    divi- 
dend, 71 
Customers,  selling  securities  to, 
294 


Dealers,  security, 

classes  of,  319 
Debenture  bonds,  149 
Debentures,  perpetual,  219 
Deeds  of  trust, 

association  under,  20 

corporate,  133 
Deferred  ordinary  shares,  English, 

70 
Deferred   shares,  English,  83 
Depreciation, 

reserves  for,  423 
Development, 

expenses  of,  178,  354 

of  industrial  combinations,  265 
Diminishing  returns, 

law  of,  367 
Directors, 

as  corporate  officers,  39 

compensation  of,  41 

contracts  with,  43 

duties,  2>T^  63 

ethical  standards,  510 


552 


INDEX 


Directors — continued 

exploitation  by,  507-513 

integrity  o£,  510 

juggling  accounts,  507 

legal  status  of,  42 

"ornamental,"  40 

rights  of,  37 
Dissolution, 

of  insolvent  corporations,  521 

voluntary,  521 
Distribution,  wide,  of  stock,  206 
Dividends,  435-464 

average  rate  of,  437 

cash  requirements  for,  451 

common  stock,  adequate  income 
for,  217 

cumulative,    on   preferred    stock, 

71 
extra,  441 

from  accumulated  surplus,  450 
funding  of,  73 
lack  of  prudence  in  paying,  effects 

of,  455 
legal  rules  affecting,  463 
non-cumulative,  71 
paying,   cause  of  insolvency, 

S17 
paying  with  borrowed  cash, 

453 

percentage    of    earnings    devoted 
to,  438 

policies  of  important  companies, 
446 

preferred  stock,  rights  as  to,  80 

prior  claim,  73 

rate  on  preferred  stock,  71 

regularity  of,  440 

rule  for  maintaining  regularity  of 
rate,  444 

scrip,  457 

stock,  459 
recapitalization  of  surplus,  197 
Dominion   of    Canada   Trust   Cor- 
poration, 


stockholders'  views  on  voluntary 
dissolution,  521 
Drafts. 
accepted,  396 
terms  of,  390 


Earning  power, 
capitalized,  179-186 
estimates  of,  186 
Earnings    (See  also  "Income") 
adjustment   to,   of   capitalization, 

184 
correct    relation    to    outstanding 

securities,  212 
gross,  honesty  in  stating,  418 
gross,  relation  to  stock  and  bond 

issues,  497 
percentage    of,    devoted   to    divi- 
dends, 438 
Eastman  Kodak  Company, 

dividend  record,  447 
Efficiency  of  corporate  form,  59 
Employees, 

selling  securities  to,  294 
Engineering  firms, 

as  promoters,  252 
Entity,  fiction  of  corporate,  26 
Equation,   human,   in  chain  stores, 

188 
Equipment  trust  bonds,  145 
Erie  Railroad, 
mortgage  bonds  of,  142 
short-time  notes  of,  128 
European  system, 
financing  merchandise  purchases, 
114 
Expenses, 
initial,  capitalization  of,  177 
of  development,  354 
of  organizing  corporation,  58 

in  Canada,  58 
operating,  428 

determination  of,  421 


INDEX 


553 


Exploitation, 

abuses    by    subordinate    officers, 
500 

a   common    evil,    505 

by  directors  and  majority  share- 
holders, 507-513 

by  officers,  499-506 

contracts  that  benefit  officers,  502 

corporate   form   favors,   499 

differing  from  fraud,  499 

divergence   of  business   to   other 
companies,  503 

enlarging  circle  of  "insiders,"  507 

exorbitant   salaries,   501 

juggling  accounts,  507 

misleading  statements,  508 

misuse  of  inside  information,  504 

of  creditors,  507 

preventives  of,  509-513 

publicity,  power  of,  512 

"squeezing"    the    minority   stock- 
holders, 508 

"unloading"  and  securing  control, 
504 
Exports, 

effect  on  working  capital,  393 

financing  of,  394 


Federal  Reserve  Bank, 

rediscounting  by,  125 
Fees  paid  in  selling  securities,  325 
Financial  crisis, 

short-term   notes   as    feature   of, 
128 
Financial  insolvency,  515 
Financial  plan,   219-228 

of  advertising  agency,  226 

of  incorporated  partnership,  221 

of  promoter,  255 

of  railroad,  224 

simplicity  desirable,  6,  228 
Financial  standards,  489-498 

analysis  based  on,  498 


cash  and  cash  resources,  493 

need  of,  489 

operating  ratios,  49s 

relation    of    working    capital    to 
total  capital,  490 

stock  and  bond  issues  in  relation 
to  gross  earnings,  497 

turnover,  495 
Financial  statements, 

basis  for  bank  credit,  124 
Financing, 

an  advertising  agency,  226 

an  incorporated  partnership,  221 

a  railroad,  224 

elementary  rules  of,  9 

export  shipments,  394 

instalment  sales,  398 

preliminary,  by  promoter,  244 

simplicity  of,  6,  228 

unskilful,  I 
Fixed  capital,  355 

calculating,  363 

relative  amount  of,   to  working, 
378 
Fixed  charges, 

reducing,  in  reorganization,  538 
"Floor  traders," 

stock  exchange,  332 
Foreign  countries, 

corporation  operating  in,  32 
Forms  of  business  enterprises,  T»- 

24 
Founders*  shares, 

use  of  in  England,  83 
Fraud    (See  "Exploitation**) 
Fund,  surplus,  465 
Funding  of  unpaid  dividends,  73 
Funds, 

foresight  in  providing,  in  promo- 
tion, 246 

"rainy-day,"  475 
G 
German  law, 

business  organization  under,  23 


554 


INDEX 


Gesellschaft  mit  Beschrankter  haf- 
tung,  23 

Good-will,  valuation  of,  191-197 

Governmental   control   of   corpora- 
tions, 57 

Gross  earnings    (See  "Earnings") 

Gross  sales, 
percentage    of,    to    capitalization, 
181 

H 

Holding  companies,  49 
advantages  of,  52 
legality  of,  51 


Illegal  combination,  50 

Imperial  Tobacco  Company,  Ltd., 

number  of  stockholders,  84 
Income    (See  also  "Net  Income") 

application  of,  9 

budget,  491 

formula  for,  415 

statements,  examples  of,  415 

steps  in  calculating,  417 
Income  bonds,  154 
Industrial  combinations, 

development  of,  265 
Industrials,  preferred  stock  of,  75 
Information,  inside, 

misuse  of,  by  officers,  504 
Inheritance, 

as  source  of  surplus,  467 
Initial  expenses, 

capitalization  of,  177 
Insolvency,  514-528 

causes  of,  516 
paying  dividends,  517 

economic,  515 

financial,  515 

lack  of  working  capital,  516 

methods  of  procedure  in  case  of, 
518 


readjustment  of  claims,  519 

technical,  515 

types  of,  515 

unfavorable     market    conditions. 

517 
Instalment  accounts, 

advances  on,  407 
Instalment  contract,  399 
Instalment  sales, 

financing  of,  398 

three  ways  of  financing,  404 

working  capital  required,  401 
Institutions    as    source    of    capital 

funds,  203 
Intangible  assets, 

represented  by  common  stock,  75 
International  Cotton  Mills  Corpor- 
ation, 

juggling  accounts,  547 

syndicate  agreement  with,  352 
Interstate  Commerce  Commission, 

report  on  status  of  N.  Y.,  N.  H. 
&  H.  R.R.,  40 
Investigation, 

preliminary,    in    promoting   com- 
binations, 273 

scope  of,  by  promoters,  234 

stages  of,  in  promoting,  230 

thoroughness    of,    in    promoting, 
231 
Investing  public, 

as  source  of  capital,  203-212 
Investment  associations, 

as  source  of  capital  funds,  203 
Investment   of    capital    funds,    354" 

379 
Investments, 
as  basis  of  capitalization,  175 
in  extensions,  364 
in  betterments,  370 
in  securities,  374 
in  side  lines,  372 
permanent  and  transient,  8 
upon  an  uncertainty,  234 


INDEX 


555 


Joint-stock  companies,  19 


"Lambs,"  as  speculators,  333 
Latin  law, 

business  organization  under,  22 
Law  of  diminishing  returns,  367 
Leases, 

advances  on,  408 
Legal  rules  affecting  dividends,  463 
Legal  status, 

of  directors,  42 

of  promoter,  256 
Lehigh  Valley  Railroad   Company, 

betterments,  concealment  of,  428 
Liabilities, 

current,  relation  to  current  assets, 
406 

quick,  357 
Liability  of  partly  paid  stock,  90 
Loans    (See  also  "Collateral"  and 
"Credit") 

bank,  factors  considered,  123 

commercial,     factors    considered, 
123 
London  Stock  Exchange,  331 

M 

Maintenance, 

reserves  for,  425 
Management  of  combinations,   289 
Management  shares, 

use  of  in  England,  83 
Manufacture, 

length  of  period  of,  381 
Manufacturers'    Commercial    Com- 
pany, 

method  of  financing  accounts  re- 
ceivable, 409 
Market, 

adaptation  of  securities  to,  209 

making  a,  on  stock  exchange,  334 


Meetings  of  stockholders,  99 
Merchandise  as  collateral,  120 
Minority  stockholders, 

squeezing  of,  508 
Montana  Power  Company, 

stock  of,  85 
Mortgage  bonds,  141 
Mortgages, 

advances  on,  408 

form    of    long-term    borrowing, 

131 

ratio  of,  to  value,  143 
Mount   Vernon-Woodberry   Cotton 
Duck  Company, 
example  of  promotion,  242,  262 

N 

National  Bankruptcy  Act,  524 
National  Biscuit  Company, 

policy  of,  365 
National  Cordage  Company, 
discrepancy    between    investment 

and  actual  value,  176 
misuse  of  inside  information  by 

officers,  504 
stock  of,  not  adapted  to  market,  211 
National      Starch      Manufacturing 
Company, 
promotion  of,  276 
Net  income    (See  also  "Income") 
determination  of,  415-434 
dividends,  435 
steps  in  calculating,  417 
Net  returns, 

percentage  to  capitalization,  182 
New  York,  New  Haven  and  Hart- 
ford R.R., 
report    on,    by    Interstate    Com- 
merce Commission,  40 
New  York   World, 

management  of,  41 
Non-competitive  companies,  51 
Non-cumulative     preferred      stock 
dividends,  71 


556 


INDEX 


"Non-stock"  corporations,  47 
Northern  Pacific, 
annual  meeting  in  1914,  100 
insolvency  of,  61 
Notes,  III 
advances  on,  408 
registered,   117 
short-term, 
selling  price,  129 
sold  to  public,  127 
use  in  financial  crisis,  128 
sold  to  brokers,  116 


Office,  principal,  of  corporation,  30 
Officers, 

abuses  by,  500 

as  directors,  39 

contracts  that  benefit,  502 

exploitation  by,  499-506 

misuse  of  inside  information,  504 
Operating  expenses,  428 

determination  of,  421 
Operating  ratios,  495 
Organization    (See  also  "Reorgan- 
ization") 

expenses,  capitalized,  178 
Organizations,  business, 

basic  types  of,  11 

under  German  law,  23 

under  Latin  law,  22 
Overcapitalization,  92 
Owned  capital    (See  "Capital") 
Ownership, 

continuity  of,  56 

corporation,  liability  of,  54 

distribution  of,  54 

transfer  of,  54 


Participating  bonds,  158 
Participating  preferred  stock,  82 
Partnership,  14 
advantages,  15 


disadvantages,  16 

incorporating,  221 
advantages,  55 

limited,  18 
Par  value  of  stock,  88 
Patents,  valuation  of,  191 
Pears,  A.  &  R,  Ltd., 

combining  with  Lever  Bros.,  Ltd., 
279 
Pennsylvania  Railroad  Company, 

number  of  stockholders,  2>7 

surplus  account  of,  474 
Personal  property,  as  collateral,  121 
Porto     Rican    American    Tobacco 
Company, 

dividend  record,  448 
Preferred  stock, 

conversion  into  common,  81 

dividend  rate,  71 

dividend  rights,  80 

general  characteristics,  82 

origin  of,  75 

participating,  82 

prior  claim  as  to  assets,  74 

prior  claim  as  to  dividends,  74 

prior  claim  as  to  voting,  74 

protection  of,  76 

use  by  industrials,  75 

use  by  railroads,  75 

uses  of,  75 

voting  power  of,  79 
Principles  of  financing,  i-io 
Proctor  and  Gamble, 

dividend  record,  447 
Profits    (See  also  "Income") 

estimated,  420 

of  promoter,  260 

variability  of,  442 
Promoter,  250-264 

business  executive  as,  254 

engineering  firm  as,  252 

financial  plan  of,  255 

forming  a  combination,  269 

legal  status  of,  256 


INDEX 


557 


Promoter — continued 

professional,  250 

profits  of,  260 

protection  of,  242 

risks  of,  258 
Promoting     combinations,     265-290 
(See  also  "Combinations") 

basis  of,  275 

difficulties,  269 

fields  for,  267 

for  greater  efficiency,  289 

industrial,  265 

investigation,  273 

management  of  combination,  289 

small,  analysis  of,  282 

to  secure  control,  286 
Promotion,      229-249       (See      also 
"Promoter,"  "Promoting 

combinations,"  and  "Combin- 
ations") 

"assembling"  a  proposition,  240 

examples  of,  262 

fields  for  combination,  267 

foresight   in   providing    funds, 
246 

investigation,  stages  of,  230 

preliminary  analysis,  232 

preliminary  financing,  244 

profits  of,  260 

protection  of  promoter,  242 

purchase    outright    of     separate 
units,  242 

risks  of,  258 

scope  of  investigation,  234 

three  steps  in,  229 

working  capital  required,  247 
Proprietorship,   sole,   12 
Prospectus, 

in  selling  securities,  313 
Protection, 

of  promoter,  242 
Proxies,  99 
Public  financing, 

relation  to  business  financing,  4 


Publicity, 

factor  in  making  a  market,  334 

power    of,    preventing    exploita- 
tion, 512 
Public  service  companies, 

capitalization  of,  199 
Purchase, 

terms  of,  388 


Railroad, 

capitalization,  per  mile,  215 

financial  plan  for,  224 

preferred  stock  of,  75 
Ratio, 

operating,  495 
Receiver      (See     also     "Receiver- 
ship") 

powers  and  duties,  525 
Receivership,  514-528 

conflicting,  520 

instances    of    voluntary    dissolu- 
tion, 522 

kinds  of  bankruptcy,  524 

origin  and  nature  of,  520 

origin  and  nature  of  bankruptcy, 

523 
powers  and  duties  of  receiver,  525 
receiver's  certificates,  526 
results  of,  526 
voluntary  dissolution,  521 
Reconstruction    (See  "Reorganiza- 
tion") 
Redemption     of     preferred     stock, 

76,  81 
Registered  stock  certificates,  87 
Registrar    as     check    on    transfer 

agent,  69 
Regulations,  internal, 
of  corporation,  S3 
Reorganization,  529-545 

American  Woolen  Company,  542 
conflict  of  interests  in,  530 
effect  on  financial  structure,  541 


558 


INDEX 


Reorganization — continued 

formation  of  committees,  501 

for  special  purposes,  542 

procedure  in,  534 

purpose  of,  529 

railroad,   reducing  fixed  charges, 
539 

raising  fresh  capital,  536 

reducing  fixed  charges,  538 

to  secure  control,  544 

use  of  preferred  stock,  75 
Repairs,  371 

reserves  for,  425 
Report,  annual,  35 
Reserve,  surplus,  465 
Reserves,  422-427 
"Right,"  subscription, 

example  of,  300 

figuring  value  of,  304 

grant  of,  298 

making  use  of,  306 
Risks, 

distribution  of,   in  underwriting, 

341 
of  promoter,  258 
Rock  Island  Company, 

combination  to  secure  control,  286 
investments  of,  376 

S 

Salaries,  exorbitant, 

form  of  exploitation,  501 
Sales, 
gross,  percentage  of,  to  capitali- 
zation, 181 
instalment, 
financing  of,  398 
three  ways  of  financing,  404 
working  capital  required,  401 
terms  of,  392 
"Scalpers"  on  stock  exchange, 

332 
Scrip  dividends,  458 


Securities, 

adaptation  of,  to  market,  209 

selling,  291-318 
Security  dealers, 

classes  of,  319,  326 
Security  issues, 

forms  of,  219 

relation  to  assets,  218 

the  choosing  of,  212 
Selling  expense, 

of  securities,  325 
Selling  securities, 

advertising,  311 

at  auction,  308 

direct,  291-318 

expense  of,  322-325 

finding  prospective  buyers,  310 

grant    of    subscription    "rights," 
298 

limitation  of  sale  through  dealers, 

324 

limitation  of  sale  through  stock 
exchange,  336 

limitations  of  direct  sale,  316 

making   a   market   on   stock   ex- 
change, 334 

methods  of,  291 

on  stock  exchange,  328 

prospectus,  313 

"tender"  method  of,  308 

through  brokers,  321 

through  dealers,  319-338 

to  customers  and  employees,  294 

to  stockholders,  292 
Shareholders    (See  "Stockholders") 
Shares    (See  "Stock") 
Sinking  funds,  161-171 

for     redemption     of     preferred 
stock,  76 
Smith,  Adam,  59 
Societe  anonyme,  22 
Societe  en  commandite,  22 
Societe  en  nom  collectif,  22 
Sources  of  capital  funds,  201-228 


INDEX 


559 


Southern  Land  Company, 

profits  of  the  promoter,  257 
Speculative, 

dealings,  importance  of,  332 

public,  as  source  of  capital  funds, 
203 

underwriting,  348 
Speculators, 

on  stock  exchange,  332 
Standard    Rope    and    Twine    Com- 
pany, 

contracts  benefiting  officers,  502 
Standards     (See   "Financial   stand- 

^  ards") 
State,  grant  of  powers  to  corpora- 
tions, 27 
Statements, 

certified,  basis  for  loans,  124 

financial,  required  for  bank  credit, 
124 

misleading,  508 
Sterling  Gum  Company, 

preparing  the  market  for  a  stock 
issue,  334 
Stetson,  J.  B.,  Co., 

dividend  record,  446 
Stock, 

adaptation  of,  to  market,  209 

as  collateral,  120 

as  dividends,  459 

capitalization  of  surplus,  197 

"assenting,"  85 

assessment  on,  in  reorganization, 
602 

bonus,  91 

"broken  lot,"  67 

certificates  of,  68,  86 

common,  68 

corporation  dealing  in  its  own,  69 

deferred,  83 

distinguished  from  shares,  67 

dividends,  cumulative,  71 

dividends,  non-cumulative,  71 

founders',  83 


full-paid,  89 

issue, 
choosing  the  right  kind,  212 
handling  of,  by  broker,  320 
relation  to  gross  earnings, 

514 
management  shares,  83 
partly  paid,  89 

liability  of,  90 
par  value,  88 

preferred,    68     (See    also    "Pre- 
ferred stock") 

as  to  assets,  T^ 

as  to  dividends,  73 

protection  of,  76 

rate  of  dividends,  71 

redemption  of,  76 

voting  rights,  79 
selling    (See  also  "Selling  secur- 
ities") 

of  smaller  corporations,  208 

on  stock  exchange,  328 
special  forms  of,  83,  219 
special  provisions,  219 
subscription  privilege  to,  299 
transfer  of,  68 
watered,  92 

wide  distribution  of,  206 
without  par  value,  95 
Stock  exchange, 
cost  of  seats,  330 
limitation  of  sale  through,  336 
London,  331 
making  a  market,  334 
methods,  328 
Stockholders, 
duties,  34 
establishing  cordial  relations  with, 

292 
exploitation  by,  507-513 
meetings,  99 
minority,  squeezing,  508 
misleading  statements  to,  508 
rights,  34 


56o 


INDEX 


Stockholders — continued 

subscription  privilege,  299 

tiring  out,  methods  of,  511 
Submarine  Boat  Corporation, 

adjustment    of    capitalization    to 
earnings,  185 
Subscription  privileges, 

grant  of,  298 

objections  to,  303 
Subsidiary  corporations,     ' 

advantages  of,  53 

use  of,  52 
Surplus,  465-481 

accumulating,  471 

as  a  source  of  capital,  478 

capitalization  by  stock  dividends, 

197 

five  sources  of,  466 

hidden,  479 

paying  dividends  from,  450 
Surplus  fund,  465 
Surplus  reserve,  465 
Syndicate  agreements,  345 
Syndicates,  underwriting,  341 

commissions  of,  348 


Tangible  assets, 

represented   by   bonds    and   pre- 
ferred stock,  75 
Taxation  of  corporations,  59 
Tax  bills, 

non-commercial  character  of,  411 
Trade  acceptances,  407 
Trade  credit,  ill 
Transfer  agent,  69 
Transfer  of  stock,  68 
Trust  companies, 

as   registrar  and  transfer  agent, 
69 
Trusts,  form  of  combination,  50 
Turnover,  495 

determining  rapidity  of,  385 

influence  on  working  capital,  384 


U 


Underwriting,  339-353 
importance  of,  340 
origin  of,  339 
speculative,  348 
syndicates,  341 
agreements,  345 
commissions  of,  348 
Underwriting  houses, 
community    of    interest    among, 

343 

Union  Pacific  Railroad  Company, 
example  of   subscription  "right," 
300 

United  Drug  Company, 
sale  of  stock  to  employees,  296 

United  States  Leather  Company, 
promotion  of,  275 

United  States  Realty  and  Construc- 
tion Company, 
example  of  promotion,  263 
syndicate   agreement  with, 

349 
United    States    Shipbuilding    Com- 
pany, 

promotion  of,  259,  350 
United  States  Steel  Corporation, 

number  of  stockholders,  37 

overcapitalization  of,  93 
"Unloading," 

by  officers,  504 
Unskilful  business  financing,  i 
Utility  corporations, 

capitalization  of,  199 


Voluntary  associations,  21 
Voting, 

cumulative,  97 

methods  of,  96 

stock  preferred,  74 
Voting  power, 

Canada,  preferred  stock,  79 


INDEX 


561 


Voting  power — continued 

distribution  by  use  of  preferred 
stock,  76 
Voting  stock, 

restriction  of,  83 
Voting  trust,  102 

W 

Warehouse  receipts, 
as  collateral,  121 

Watered  stock,  92 

Westinghouse  Electric  and  Manu- 
facturing Company, 
"assenting"  stock  of,  85 
reckless  use  of  capital   funds, 

357 
Westinghouse,  George, 
inventor  and  organizer,  2 


Working  capital, 
affected  by  length  of  period  of 

manufacture,  381 
affected  by  terms  of  purchase,  388 
calculating  requirements  of,  380- 

414 
effect  of  seasonal  changes,  412 
factors  that  affect,  361 
factors  to  be  considered,  380 
influenced  by  terms  of  sale,  392 
in  instalment  selling,  401 
lack  of,  cause  of  insolvency,  516 
month-by-month  calculations,  413 
necessity  for  adequate,  357 
providing,  355 
relation  to  total,  490 
relation  to  turnover,  384 
relative  amount  of,  to  fixed,  378 
required,  in  new  proposition,  247 


i 


YC  23727 
I 


9 


h<3^ 


i'y'd^^ 


UNIVERSITY  OF  CALIFORNIA  UBRARY 


